policies, measures, and instruments · the purpose of this chapter is to examine the major types of...

Co-ordinating Lead Authors:IGOR BASHMAKOV (RUSSIAN FEDERATION), CATRINUS JEPMA(NETHERLANDS)

Lead Authors:Peter Bohm (Sweden), Sujata Gupta (India), Erik Haites (Canada), Thomas Heller(USA), Juan-Pablo Montero (Chile), Alberto Pasco-Font (Peru), Robert Stavins(USA), John Turkson† (Ghana), Huaqing Xu (China), Mitsutsune Yamaguchi (Japan)

Contributing Authors:Scott Barrett (UK), Andrew Dearing (UK), Bouwe Dijkstra (Netherlands), Ed Holt(USA), Nathaniel Keohane (USA), Shinya Murase (Japan), Toshio Nakada (Japan),William Pizer (USA), Farhana Yamin (Pakistan)

Review Editors:Dilip Ahuja (India), Peter Wilcoxen (USA)

Policies, Measures, and Instruments

6

Executive Summary 401

6.1 Introduction 404

6.1.1 Introduction and Key Questions 4046.1.2 Types of Policies, Measures, and Instruments 4046.1.3 Policy Developments since the Second

Assessment Report 4056.1.4 Criteria for Policy Choice 4066.1.5 The Political Economy of National

Instrument Choice 4076.1.5.1 Key Lessons from the Political

Economy Literature 4076.1.5.2 Implications for Global Climate

Change Policy 408

6.2 National Policies, Measures, and Instruments 4096.2.1 Non-Climate Policies with Impacts on

Greenhouse Gas Emissions 4096.2.1.1 Structural Reform Policies 4096.2.1.2 Price and Subsidy Policies 4106.2.1.3 Liberalization and Restructuring of

Energy Markets 4106.2.2 Climate and Other Environmental Policies 412

6.2.2.1 Regulatory Standards 4126.2.2.2 Emissions Taxes and Charges 4136.2.2.3 Tradable Permits 4156.2.2.4 Voluntary Agreements 4176.2.2.5 Informational Instruments 4196.2.2.6 Subsidies and other Incentives 421

6.2.3 Mixes of National Policy Instruments 422

6.3 International Policies, Measures, and

Instruments 4246.3.1 International Emissions Trading 4256.3.2 Project-based Mechanisms (Joint

Implementation and the Clean Development Mechanism) 4266.3.2.1 Joint Implementation (Article 6) 4266.3.2.2 The Clean Development Mechanism

(Article 12) 4266.3.2.3 Baselines 427

6.3.2.4 Experience with Activities Implemented Jointly 428

6.3.3 Direct International Transfers 4296.3.3.1 Financial Resources 4296.3.3.2 Technology Transfer 429

6.3.4 Other Policies and Instruments 4306.3.4.1 Regulatory Instruments 4306.3.4.2 International and Harmonized

(Domestic) Carbon Taxes 4306.3.4.3 Standardization of Measurement

Procedures 4316.3.4.4 International Voluntary Agreements

with Industry 4316.3.5 International Climate Change Agreements:

Participation, Compliance, and Liability 4326.3.5.1 Participation 4326.3.5.2 Compliance 4326.3.5.3 Liability 433

6.4 Interrelations Between International and

National Policies, Measures, and Instruments 4346.4.1 Relationship Between Domestic Policies and

Kyoto Mechanisms 4346.4.2 Conflicts with International Environmental

Regulation and Trade Law 4356.4.3 International Co-ordination of Policy

Packages 4386.4.4 Equity, Participation, and International Policy

Instruments 438

6.5 Key Considerations 4406.5.1 Price versus Quantity Instruments 4406.5.2 Interactions of Policy Instruments with

Fiscal Systems 4416.5.3 The Effects of Alternative Policy Instruments

on Technological Change 4416.5.3.1 Theoretical Analyses 4426.5.3.2 Empirical Analyses 442

6.6 Climate Policy Evaluation 443

References 444

CONTENTS

The purpose of this chapter is to examine the major types ofpolicies and measures that can be used to mitigate net concen-trations of greenhouse gases (GHGs) in the atmosphere.1

Alternative policy instruments are described and assessed interms of specific criteria, on the basis of the most recent litera-ture. Naturally, emphasis is on the instruments mentioned inthe Kyoto Protocol (the Kyoto mechanisms), because theyfocus on achieving GHG emissions limits, and the extent oftheir envisaged international application is unprecedented. Inaddition to economic dimensions, political, economic, legal,and institutional elements are considered insofar as they arerelevant to the discussion of policies and measures.

Any individual country can choose from a large set of possiblepolicies, measures, and instruments to limit domestic GHGemissions. These can be categorized into market-based instru-ments (which include taxes on emissions, carbon, and/or energy,tradable permits, subsidies, and deposit–refund systems), regu-latory instruments (which include non-tradable permits, tech-nology and performance standards, product bans, and directgovernment spending, including research and developmentinvestment) and voluntary agreements (VAs) of which some fallin the category of market-based instruments. Likewise, a groupof countries that wants to limit its collective GHG emissionscould agree to implement one, or a mix, of instruments. Theseare (in arbitrary order) tradable quotas, Joint Implementation(JI), the Clean Development Mechanism (CDM), harmonizedtaxes on emissions, carbon, and/or energy, an international taxon emissions, carbon, and/or energy, non-tradable quotas, inter-national technology and product standards, VAs, and directinternational transfers of financial resources and technology.

Possible criteria for the assessment of policy instrumentsinclude environmental effectiveness, cost effectiveness, distri-bution considerations, administrative and political feasibility,government revenues, wider economic effects, wider environ-mental effects, and effects on changes in attitudes, awareness,learning, innovation, technical progress, and dissemination oftechnology. Each government may apply different weights tovarious criteria when evaluating policy options for GHG miti-gation, depending on national and sector-level circumstances.Moreover, a government may apply different sets of weights tothe criteria when evaluating national (domestic) versus inter-national policy instruments.

The economics literature on the choice of policies adoptedemphasizes the importance of interest-group pressures, focus-ing on the demand for regulation. However, it has tended toneglect the “supply side” of the political equation, which isemphasized in the political science literature of the legislatorsand government and party officials who design and implementregulatory policy, and who ultimately decide which instru-ments or mix of instruments will be used. The point of compli-ance of alternative policy instruments, whether they areapplied to fossil fuel users or manufacturers, for example, islikely to be politically crucial to the choice of policy instru-ment. And a key insight is that some forms of regulation actu-ally benefit the regulated industry, for example, by limitingentry into the industry or by imposing higher costs on newentrants. A policy that imposes costs on industry as a wholemight still be supported by firms who, as a consequence, wouldfare better than their competitors. Regulated firms, of course,are not the only group with a stake in regulation: opposinginterest groups will fight for their own interests.

To develop reasonable assessments of the feasibility ofimplementing GHG mitigation policies in countries in theprocess of structural reform, it is important to understand thisnew policy context. Recent measures taken to liberalize ener-gy markets were inspired mainly by desires to increase com-petition in energy and power markets, but they can have sig-nificant emissions implications also, through their impact onthe production and technology pattern of energy and/orpower supply. In the long run, the consumption patternchange might be more important than the sole implementa-tion of climate change mitigation measures (e.g. see Chapter2, the B1 scenario).

Market-based instruments–principally domestic taxes anddomestic tradable permit systems–are attractive to govern-ments in many cases because they are efficient; they are fre-quently introduced in concert with conventional regulatorymeasures. When implementing a domestic emissions tax, poli-cymakers must consider the collection point, the tax base, thevariation or uniformity among sectors, the association withtrade, employment, revenue, and the exact form of the mecha-nism. Each of these can influence the appropriate design of adomestic emissions tax, and political or other concerns arelikely to play a role also. For example, a tax levied on the ener-gy content of fuels could be much more costly than a carbontax for the equivalent emissions reduction, because an energytax raises the price of all forms of energy, regardless of theircontribution to carbon dioxide emissions. Yet, many nationsmay choose to use energy taxes for reasons other than cost-

401Policies, Measures, and Instruments

EXECUTIVE SUMMARY

1 In keeping within the defined scope of Working Group III, policiesand measures that can be used to reduce the costs of adaptation to cli-mate change are not examined.

effectiveness, and much of the analysis in this chapter appliesto energy taxes as well as to carbon taxes.

A country committed to a limit on its GHG emissions can alsomeet this limit by implementing a tradable permit system thatdirectly or indirectly limits emissions of domestic sources.Like taxes, permit systems pose a number of design issues,including type of permit, sources included, point of compli-ance, and use of banking. To cover all sources with a singledomestic permit regime is unlikely. The certainty provided bya tradable permit system that a given emission level for partic-ipating sources is achieved incurs the cost of uncertain permitprices (and hence compliance costs). To address this concern,a hybrid policy that caps compliance costs could be adopted,but the level of emissions would no longer be guaranteed.

For a variety of reasons, in most countries the management ofGHG emissions will not be addressed with a single policy instru-ment, but with a portfolio of instruments. In addition to one ormore market-based policies, a portfolio might include standardsand other regulations, VAs, and information programmes:

• Energy-efficiency standards have reduced energy use ina growing number of countries. Standards may alsohelp develop the administrative infrastructure needed toimplement market-based policies. The main disadvan-tage of standards is that they can be inefficient, but effi-ciency can be improved if the standard focuses on thedesired results and leaves as much flexibility as possi-ble in the choice of how to achieve the results.

• VAs may take a variety of forms. Proponents of VAspoint to low transaction costs and consensus elements,while sceptics emphasize the risk of free riding, and therisk that the private sector will not pursue real emis-sions reduction in the absence of monitoring andenforcement.

• Imperfect information is widely recognized as a keymarket failure that can have significant effects onimproved energy efficiency, and hence emissions.Information instruments include environmentallabelling, energy audits, and industrial reportingrequirements, and information campaigns are market-ing elements in many energy efficiency programmes.

A growing literature demonstrates theoretically, and withnumerical simulation models, that the economics of addressingGHG reduction targets with domestic policy instrumentsdepends strongly on the choice of those instruments. The inter-action of abatement costs with the existing tax structure and,more generally, with existing factor prices is important.Policies that generate revenues can be coupled with policymeasures that improve the efficiency of the tax structure.

Turning to international policies and measures, the KyotoProtocol defines three international policy instruments, the so-called Kyoto mechanisms: international emissions trading(IET), JI, and CDM.2 Each of these international policy instru-ments provides opportunities for Annex I Parties3 to fulfil their

commitments cost-effectively. IET essentially allows Annex IParties to exchange part of their assigned amounts (AAs). IETimplies that countries with high marginal abatement costs(MACs) may acquire emissions reductions from countrieswith low MACs. Similarly, JI allows Annex I Parties toexchange emissions reduction units among themselves on aproject-by-project basis. Under the CDM, Annex I Partiesreceive Certified Emissions Reduction (CERs)–on a project-by-project basis–for reductions accomplished in non-Annex Icountries.

Economic analyses indicate that the Kyoto mechanisms couldreduce significantly the overall cost of meeting the Kyotoemissions limitation commitments. However, to achieve thepotential cost savings requires the adoption of domestic poli-cies that allow the use the mechanisms to meet their nationalemissions limitation obligations. If domestic policies limit theuse of the Kyoto mechanisms, or international rules that gov-ern the mechanisms limit their use, the cost savings may bereduced.

In the case of JI, host governments have incentives to ensurethat emission reduction units are issued only for real emissionreductions, assuming that they face strong penalties for non-compliance with national emissions limitation commitments.In the case of CDM, a process for independent certification ofemission reductions is crucial, because host governments donot have emissions limitation commitments and hence mayhave less incentive to ensure that certified emission reductionsare issued for real emission reductions only. The main difficul-ty in implementing project-based mechanisms, both JI andCDM, is to determine the net additional emissions reductions(or sink enhancement) achieved. Various other aspects of theseKyoto mechanisms await further decision making, includingmonitoring and verification procedures, financial additionality(assurance that CDM projects do not displace traditional devel-opment-assistance flows) and other additionalities, and possi-

Policies, Measures, and Instruments402

2 The ability of two or more Annex I Parties to form a “bubble” underArticle 4 of the Kyoto Protocol is sometimes classified as one of theflexibility mechanisms as well. This mechanism allows a one timeredistribution of the emissions limitation commitments among the par-ticipants. Since such a redistribution is strictly a political decision thismechanism is not discussed here.

3 Annex I Parties to the UNFCCC (as amended by decision 4/CP.3)include all 39 Parties (38 countries plus the European EconomicCommunity) listed in Annex B of the Protocol that will have quanti-fied emissions limitation or reduction commitments for the 2008 to2012 commitment period, plus Turkey and Belarus, which are Partiesto the Convention but not listed in Annex B of the Protocol. To be pre-cise, one should refer to the commitments of Annex I Parties listed inAnnex B of the Kyoto Protocol. To avoid confusion, the term Annex Icountries is used throughout this chapter to refer to Annex I Partieslisted in Annex B of the Protocol; Turkey and Belarus are understoodto be included within this umbrella term, but not within the group ofcountries that will have limitation commitments.

ble means of standardizing methodologies for project base-lines.

The extent to which developing country (non-Annex I) Partieseffectively implement their commitments under the UnitedNations Framework Convention on Climate Change (UNFC-CC; referred to as the Convention in this chapter) may dependon the effective implementation by developed country Partiesof their commitments under the Convention related to thetransfer of financial resources and technology. The transfer ofenvironmentally sound technologies from developed to devel-oping countries is now seen as a major element of globalstrategies to achieve sustainable development and climate sta-bilization.

Any international or domestic policy instrument can be effectiveonly if accompanied by adequate systems of monitoring andenforcement. There is a linkage between compliance enforce-

ment and the amount of international co-operation that will actu-ally be sustained. Many multilateral environmental agreementsaddress the need to co-ordinate restrictions on conduct taken incompliance with the obligations they impose and the expandinglegal regime under the World Trade Organization (WTO) andGeneral Agreement on Tariff and Trade (GATT) umbrella.Neither the UNFCCC nor the Kyoto Protocol provides for spe-cific trade measures in response to non-compliance. But severaldomestic policies and measures that might be developed andimplemented in conjunction with the Kyoto Protocol could con-flict with WTO provisions. International differences in environ-mental regulation may have trade implications also.

One of the main concerns in environmental agreements (includ-ing the UNFCCC and the Kyoto Protocol) is with reachingwider participation. The literature on international environmen-tal agreements predicts that participation will be incomplete, andso further incentives may be needed to increase participation.


6.1 Introduction

6.1.1 Introduction and Key Questions

The main purpose of this chapter is to discuss the various poli-cies and measures in relation to the different criteria that can beused to assess them, on the basis of the most recent literature.There is obviously a relatively heavy focus on the Kyoto instru-ments, because they focus on climate policy, have been agreedsince the IPCC Second Assessment Report (SAR; IPCC, 1996,Section 11.5), and the extent of their envisaged internationalapplication is unprecedented. Wherever feasible, political eco-nomic, legal, and institutional elements are discussed insofar asthey are relevant to the implementation of policies and measures.To make both theoretical and practical points the chapter offersoccasional examples of policy instrument application, but theeffort in this regard is limited by the existing literature, which isweighted towards the experience of industrialized countries.4

The chapter does not systematically discuss policies and mea-sures typically used to encourage sector-specific technologies;such policies and measures are described in Chapters 3, 4, and5. The emphasis is on the general description and assessmentof policies and measures.

6.1.2 Types of Policies, Measures, and Instruments

A country can choose from a large set of policies, measures,and instruments to limit domestic greenhouse gas (GHG) emis-sions or enhance sequestration by sinks. These include (in arbi-trary order): (1) taxes on emissions, carbon, and/or energy, (2)tradable permits5, (3) subsidies6, (4) deposit–refund systems,(5) voluntary agreements (VAs), (6) non-tradable permits, (7)technology and performance standards, (8) product bans, and(9) direct government spending and investment. Definitions ofthese instruments are provided in Box 6.1. The first four areoften called market-based instruments, although some VAsalso fall into this category.

A group of countries that want to limit their collective GHGemissions could agree to implement one, or a mix, of instru-

ments. These are (in arbitrary order):• tradable quotas;• Joint Implementation (JI);• the Clean Development Mechanism (CDM);• harmonized taxes on emissions, carbon, and/or energy;• an international tax on emissions, carbon, and/or energy;


4 While an exhaustive review of in-country experiences with policyinstruments is beyond the scope of this chapter, other recent workshave focused on this issue (Panayotou, 1998; Huber et al., 1999;Speck, 1999; Stavins, 2000).

5 What makes a tradable permit a market-based instrument is the pos-sibility of trading the permit, not the initial allocation of the permits(unless such allocation is through auction). The SAR adopted the con-vention of using “permits” for domestic trading systems and “quotas”for international trading systems. This convention is followedthroughout the chapter.

6 Sometimes taxes are combined with subsidies, known as“fee/rebate”.

Box 6.1. Definitions of Selected National Greenhouse GasAbatement Policy Instruments

• An emissions tax is a levy imposed by a government on eachunit of emissions by a source subject to the tax. Since virtual-ly all of the carbon in fossil fuels ultimately is emitted as CO2,a levy on the carbon content of fossil fuels–a carbon tax–isequivalent to an emissions tax for emissions caused by fossilfuel combustion. An energy tax–a levy on the energy contentof fuels–reduces the demand for energy and so reduces CO2emissions through fossil fuel use.

• A tradable permit (cap-and-trade) system establishes a limiton aggregate emissions by specified sources, requires eachsource to hold permits equal to its actual emissions, andallows permits to be traded among sources. This is differentfrom a credit system, in which credits are created when asource reduces its emissions below a baseline equal to an esti-mate of what they would have been in the absence of theemissions reduction action. A source subject to an emissions-limitation commitment can use credits to meet its obligation.

• A subsidy is a direct payment from the government to an enti-ty, or a tax reduction to that entity, for implementing a prac-tice the government wishes to encourage. GHG emissions canbe reduced by lowering existing subsidies that in effect raiseemissions, such as subsidies to fossil fuel use, or by providingsubsidies for practices that reduce emissions or enhance sinks(e.g., for insulation of buildings or planting trees).

• A deposit–refund system combines a deposit or fee (tax) on acommodity with a refund or rebate (subsidy) for implementa-tion of a specified action.

• A VA is an agreement between a government authority andone or more private parties, as well as a unilateral commit-ment that is recognized by the public authority, to achieveenvironmental objectives or to improve environmental per-formance beyond compliance.

• A non-tradable permit system establishes a limit on the GHGemissions of each regulated source. Each source must keepits actual emissions below its own limit; trading amongsources is not permitted.

• A technology or performance standard establishes minimumrequirements for products or processes to reduce GHG emis-sions associated with the manufacture or use of the productsor processes.

• A product ban prohibits the use of a specified product in aparticular application, such as hydrofluorocarbons (HFCs) inrefrigeration systems, that gives rise to GHG emissions.

• Direct government spending and investment involves gov-ernment expenditures on research and development (R&D)measures to lower GHG emissions or enhance GHG sinks.

• non-tradable quotas;• international technology and product standards;• international VAs; and• direct international transfers of financial resources and

technology.

Box 6.2 defines some of the instruments most prominently dis-cussed in the literature. The first five are often called market-based instruments, although VAs can fall into this categoryalso.

6.1.3 Policy Developments since the Second AssessmentReport

In December 1997, Parties to the United Nations FrameworkConvention on Climate Change8 negotiated the Kyoto Protocol(UNFCCC, 1997). The Protocol established, for the first time,legally binding quantified emissions limitation and reduction

commitments that cover the emissions of six GHGs from awide range of sources for the period 2008 to 2012 for 38 coun-tries and the European Economic Community (EEC; Annex IParties). These commitments represent a 5.2% reduction fromthe 1990 emissions of the Annex I Parties, and a 10% to 20%reduction from their projected emissions during the 2008 to2012 period.

Annex I Parties can meet their commitments through measuresto reduce domestic emissions, specified actions to enhancedomestic sinks, and co-operative action with other Partiesunder Articles 4, 6, 12, or 17. Article 4 allows a group of AnnexI Parties to agree to reallocate their collective emissions reduc-tion commitment and to fulfil this commitment jointly. Such anarrangement is commonly referred to as a “bubble”. The mem-bers of the EEC are the only countries, to-date, to indicate thatthey are likely to establish one “bubble” to meet their commit-ments.

Article 6 defines JI for Annex I Parties, Article 12 establishesthe CDM for projects in non-Annex I countries, and Article 17allows emissions trading, a form of tradable quota, amongAnnex B Parties (see Box 6.2). The principles, modalities,rules, and guidelines for these three Kyoto Protocol mecha-nisms remain to be finalized. The Fourth Session ofConference of the Parties (CoP4) in Buenos Aires in November


Box 6.2. Definitions of Selected International Greenhouse Gas Abatement Policy Instruments

• A tradable quota system establishes national emissions limits for each participating country and requires each country to hold quotaequal to its actual emissions. Governments, and possibly legal entities, of participating countries are allowed to trade quotas.Emissions trading under Article 17 of the Kyoto Protocol is a tradable quota system based on the assigned amounts (AAs) calcu-lated from the emissions reduction and limitation commitments listed in Annex B of the Protocol.

• JI allows the government of, or entities from, a country with a GHG emissions limit to contribute to the implementation of a pro-ject to reduce emissions, or enhance sinks, in another country with a national commitment and to receive emission reduction units(ERUs) equal to part, or all, of the emissions reduction achieved. The ERUs can be used by the investor country or another AnnexI party to help meet its national emissions limitation commitment. Article 6 of the Kyoto Protocol establishes JI among Parties withemissions reduction and limitation commitments listed in Annex B of the Protocol.

• The CDM allows the government of, or entities from, a country with a GHG emissions limit to contribute to the implementationof a project to reduce emissions, or possibly enhance sinks, in a country with no national commitment and to receive CERs equalto part, or all, of the emissions reductions achieved. Article 12 of the Kyoto Protocol establishes the CDM to contribute to sus-tainable development of the host country and to help Annex I Parties meet their emissions reduction and limitation commitments.

• A harmonized tax on emissions, carbon, and/or energy commits participating countries to impose a tax at a common rate on thesame sources.7 Each country can retain the tax revenue it collects.

• An international tax on emissions, carbon, and/or energy is a tax imposed on specified sources in participating countries by an inter-national agency. The revenue is distributed or used as specified by participant countries or the international agency.

• Non-tradable quotas impose a limit on the national GHG emissions of each participating country to be attained exclusively throughdomestic actions.

• International product and/or technology standards establish minimum requirements for the affected products and/or technologiesin countries in which they are adopted. The standards reduce GHG emissions associated with the manufacture or use of the prod-ucts and/or application of the technology.

• An international VA is an agreement between two or more governments and one or more entities to limit GHG emissions or toimplement measures that will have this effect.

• Direct international transfers of financial resources and technology involve transfers of financial resources from a national gov-ernment to the government or legal entity in another country, directly or via an international agency, with the objective of stimu-lating GHG emissions reduction or sink enhancement actions in the recipient country.

7 A harmonized tax does not necessarily require countries to impose atax at the same rate, but to impose different rates across countrieswould not be cost-effective.

8 That is, those countries that ratified the Convention, 186 countries asof September 2000.

1998 adopted a Plan of Action that includes development ofthese principles, modalities, rules, and guidelines for adoptionat CoP6 at The Hague in November 2000.9

Annex I Parties have been implementing domestic policies toaddress their commitment under Article 4.2 of the Conventionand evaluating possible policies to meet their more stringentcommitments under the Protocol, taking into account theoptions afforded by the Kyoto mechanisms. Annex I Parties’national climate programmes are described in their NationalCommunications, which are compiled by the UNFCCCSecretariat and subjected to external expert review under theConvention (UNFCCC, 1999, addenda 1-2).

Structural adjustment and energy sector reforms have beenpursued in many countries. Although these are not GHG poli-cies, they often have significant implications for GHG emis-sions, increasing or reducing emissions depending upon thecircumstances (see Section 6.2).

6.1.4 Criteria for Policy Choice

Governments implement policies and measures to achieve par-ticular objectives that they believe will not be achieved in theabsence of government intervention, possibly because exter-nalities or public goods are involved. Policies and measurescan be generic, such as a general carbon tax or emissions trad-ing, or sector-specific, such as a regulation applied to the con-struction sector, or a subsidy for green farming practices. Theobjective of this chapter is to assess different types of policiesand measures, not to provide a complete list of these, so sector-specific policies and measures are discussed only in generalterms.

Chapter 5 draws a distinction among five types of policy tar-gets, each of which refers to a different interpretation (defini-tion) of the concept of “barriers” to technological change: mar-ket potential, economic potential, socioeconomic potential,technological potential, and physical potential. Policies andmeasures can differ in the type of potential they aim to reach,but it is difficult to link specific policy instruments and specif-ic potentials, because the potential achieved through virtuallyany policy instrument depends upon the “degree” to which thatinstrument is employed. For example, an emissions tax can beset at various levels; depending upon the level at which theemissions tax is set, it could have the effect (if perfectly imple-mented) of achieving any of the types of “potential” defined inChapter 5.10 For this, among other reasons, the prime focus in

this section is on the possible criteria for policy instrumentchoice and evaluation.

Evaluation criteria are required both for the ex-ante choice ofinstruments and for the ex-post assessment of implementationand performance. Each government may apply differentweights to the criteria when it evaluates GHG mitigation poli-cy options.11 Moreover, a government may apply differentweights to the criteria when it evaluates national and interna-tional policy instruments, and the appropriateness of the crite-ria may vary depending on the degree of uncertainty about thepollution abatement cost and pollution damage functions. Thisgeneral remark should be kept in mind when the variousdomestic and international policies, instruments, and measuresdiscussed in this chapter are evaluated against the backgroundof these criteria.

The criteria identified in SAR for the evaluation of policyoptions (Fischer et al., 1998) are:

• Environmental effectiveness. How well does the policyachieve the environmental goal, such as a GHG emis-sions reduction target? How reliable is the instrumentin achieving that target, does the instrument’s effective-ness erode over time, and does the instrument createcontinual incentives to improve products or processesin ways that reduce emissions?

• Cost-effectiveness. Whether the policy achieves theenvironmental goal at the lowest cost, taking transac-tion, information, and enforcement costs into account.

• Distributional considerations. How the costs of achiev-ing the environmental goal are distributed acrossgroups within society, including future generations.

• Administrative and political feasibility. This includesconsiderations such as flexibility in the face of new


9 The Plan of Action also includes work on the development and trans-fer of technologies, the financial mechanism, implementation ofArticles 4.8 and 4.9 of UNFCCC, and preparations for the first sessionof the CoP serving as the meeting of the Parties to the Kyoto Protocol.This involves, inter alia, decisions on rules that govern sink enhance-ment activities under Articles 3.3 and 3.4 of the Kyoto Protocol.

10 However, some concepts of “barriers” seem to imply combinationsof instruments and levels or degrees of implementation. For example,if the problem is viewed as one of externalities, it is natural to use atax on the relevant externality, with the tax set equal to the marginalsocial damages at the efficient level of control. On the other hand,although categories of “potential” refer to targets (ends), categories ofpolicy instruments refer to the means of achieving those ends.

11 The choice of weights is strongly influenced by many national andsector-level circumstances. These include government jurisdictionalstructure (e.g., sharing of government powers at various levels); geo-graphical and climate profile (e.g., area size, regional weather pat-terns, heating degree days and temperature distribution, annual tem-perature variations, climate variability, latitude); economic setting(e.g., gross domestic product (GDP), GDP/capita, and GDP by sec-tor); international trade patterns, such as percentage of energy-inten-sive exports; energy and natural resource base; demographics (e.g.,population total and distribution, growth rate); land use and/or spatialpatterns (e.g., distances driven/capita); industry and agriculture struc-ture; building stock, and urban structure (e.g., home sizes); and envi-ronmental and/or health patterns (e.g., potential for highly variableclimate change mitigation impacts across different national regionsand urban areas).

knowledge, understandability to the general public,impacts on the competitiveness of different industries,and other government objectives (such as meeting fis-cal targets and reducing emissions of pollutants).

The literature (e.g., OECD, 1997d) identifies some additionalcriteria, such as:

• Revenues raised in the case of market mechanisms, forinstance, may constitute a second source of benefitsfrom their use, over and above their direct environmen-tal impact, depending on if and how the revenues arerecycled.

• Wider economic effects include potential effects onvariables such as inflation, competitiveness, employ-ment, trade, and growth.

• Wider environmental effects, such as local air-qualityimprovement (usually referred to as the ancillary bene-fits).

• “Soft” effects, which relate to the impact of environ-mental policy instruments on changes in attitudes andawareness.

• Dynamic effects, which relate to the impact on learn-ing, innovation, technical progress, and disseminationand transfer of technology.

The above lists of criteria guide the discussion of national andinternational policies and measures related to GHG abatement.However, the economics literature–particular theory develop-ment–focuses more on the cost-effectiveness criterion than onthe other criteria mentioned, and there is a similar emphasis inthis chapter, which is a review of the best available scientificliterature. Wherever possible, literature on the potential equityimpact of policies and measures is referred to. In addition, spe-cific attention is paid to the political economy literature thatdescribes policy choice (Section 6.1.5), the interactions of pol-icy instruments with fiscal systems (Section 6.5.2), and theimpacts on technological change (Section 6.5.3).

6.1.5 The Political Economy of National InstrumentChoice

Some of the key lessons from the scholarly literature on polit-ical economy can be applied to instrument choice in climatepolicy at the national level. Since much of that scholarshipfocuses on policymaking in a limited set of developed nations,in particular in the USA, great care must be taken before apply-ing any of these lessons to domestic politics generally.

6.1.5.1 Key Lessons from the Political Economy Literature

A useful starting-point is to view the policy process (at least incountries with strong legislatures) as analogous to a “politicalmarket” (Keohane et al., 1999). The demand side of such a“market” consists of the interest groups with a stake in the pol-icy; in the environmental arena, such groups include regulatedindustries, producers of complementary products, environmen-

tal organizations, and (to a lesser extent) labour and consumerorganizations. The supply side consists of the legislators andthe administration involved in the design and implementationof the environmental policies and measures.

One key insight of this literature is that some forms of regula-tion can actually benefit the regulated industry, for example, bylimiting entry into the industry or imposing higher costs onnew entrants (Rasmusen and Zupan, 1991; Stigler, 1971). Inthe environmental arena, conventional regulation may providefirms with rents that result from reductions in output and raisedprices as a consequence of regulation (Buchanan and Tullock,1975; Maloney and McCormick, 1982). Stricter standards fornew pollution sources benefit existing firms by raising barriersto entry (Nelson et al., 1993). Polluters’ self-interest may alsohelp explain the prevalence of tradable permits that have beenallocated free (“grandfathered”) when market-based instru-ments have been used. Permits allocated free to existing firmsrepresent a transfer of rents from government to industry whileauctioned permits and emissions taxes generally impose aheavier burden on polluters. Finally, VAs may be the preferredpolicy approach from industry’s perspective, because theseleave more of the initiative with the private sector (at least soit is perceived), which may enhance industry’s chances of cap-turing rents.

Of course, it is important to recognize that industry may not actmonolithically, since policies may have differential distribu-tional impacts within a sector. A policy that imposes costs onindustry as a whole might still be supported by firms thatwould fare better than their competitors. For example, firmsthat can achieve emissions reductions more cheaply may bemore supportive of market-based schemes, such as tradablepermits, than their higher-cost competitors (Kerr and Maré,1997). In the realm of global environmental policy, the ban onozone-depleting chlorofluorocarbons (CFCs) under theMontreal Protocol was, for instance, supported by those whoexpected to dominate the market for HFCs, then the leadingsubstitute chemicals (Oye and Maxwell, 1995).

Regulated firms are not the only group with a stake in regula-tion; opposing interest groups will defend their own interests.Environmental groups, for example, tend to favour stringenttargets, although many have opposed market-based instrumentsout of a philosophical concern that such policies give firms“licenses to pollute” or because of objections to attempts toquantify or monetize the environmental damages from pollu-tion (Kelman, 1981; Hahn, 1989; Sandel, 1997). Some groupsdraw an ethical distinction between taxes and tradable permitsystems, in which taxes are morally deficient because they puta price on emissions but set no upper limit on allowable pollu-tion, while permits ensure a set level of emissions (Goodin,1994). Other environmental groups support market-based poli-cies in the hope that the resultant cost savings will make a high-er level of environmental quality politically attainable, and pos-sibly in part because of their own self-interest in distinguishingthemselves from other environmental organizations (Svendsen,


1999). The US Clean Air Act defines permits as “limited autho-rizations to emit”, to avoid limiting the ability to set loweremissions limits, which may also be a response to concerns ofthe environmental lobby that air should not become privateproperty (Tietenberg, 1998). This indicates that the design ofmarket-based instruments may be flexible enough to accommo-date ethical concerns without undermining effectiveness.

While the political economy literature emphasizes the impor-tance of preferences of interest groups, it has tended to neglectthe “supply side” of the political equation: the legislators andgovernment officials who ultimately design and implementregulatory policy. Government actors may have their owninterests and preferences with respect to policy instruments:

• ideology or past experience may favour one instrumentover another (Kneese and Schulze, 1975; Hahn andStavins, 1991);

• legislators may prefer policies with (large but) hiddencosts to those with (small but) visible ones (McCubbinsand Sullivan, 1984; Hahn, 1987); and

• legislators responsible to local districts may emphasizedistributional concerns over efficiency (Shepsle andWeingast, 1984).

Finally, the environmental administration may prefer directregulation over market-based instruments, not only insofar asthey are more familiar with it, but also because it gives themmore control, and usually requires a relatively large adminis-trative capacity.

These political factors, however, vary widely among coun-tries. Whether or not a legislature exists, and if so whether ina parliamentary or presidential system, affects the support forparticular policy instruments. Whether legislators are electedby district or by party list may affect the political support fordifferent policy instruments as well. Factors such as the extentof interest-group organization and how groups interact withgovernment are also critical–interest groups lobby legislatorsin some countries, sit on quasi-governmental decision-makingbodies in others, are relegated to raising public awarenesselsewhere, and in some countries are non-existent. Less tangi-ble cultural and historical factors can also be critical in influ-encing the choice of instrument. For example, a country’sexperience with free markets generally may influence whetheror not it chooses to use market-based policy instruments forenvironmental protection (Keohane, 1998). Finally, there areclear political economy limitations of individually appliedprice, non-price, and regulatory policies that often lead to thelinked or combined policy strategy that is observed in prac-tice.

6.1.5.2 Implications for Global Climate Change Policy

Since the political factors on the “supply side” are so hetero-geneous across nations, the focus here is on the demand forregulations, building on the literature reviewed above to drawconclusions about the likely preferences and positions of key

interest groups involved in climate change policy. Five groupsseem particularly important: environmental organizations(especially in the USA and Europe), producers of carbon-basedfuels (e.g., coal and oil producers), large users of fuel (e.g.,electric utilities), manufacturers of energy-using products (e.g.,automobile manufacturers), and manufacturers of energy-effi-cient and GHG-abatement technologies (e.g., manufacturers ofefficient lighting). Environmental organizations in the USAand Europe seem to be divided–some groups have embracedmarket-based policies such as emissions permits and carbontaxes, while others object to such policies being applied with-out restrictions. Some also object to the option of so-calledexchanges of “hot air” (national quota surpluses not created byactive policies).

The range of industry sectors with large stakes in global cli-mate policy suggests an important point: the various regulato-ry instruments that might be employed in climate change poli-cy would each act at different levels of regulation, creating dif-ferent points of compliance with very different implications forinterest groups. Examples are:

• a system of tradable carbon permits (or a carbon tax, forthat matter) imposed at the mine mouth, wellhead, orpoint-of-entry directly affects fuel producers (althoughthe true economic incidence of the policy would beshared by downstream firms and consumers accordingto relative elasticities);

• a CO2 tax, tradable emissions permit system, or emis-sions standard directly affects power plants; and

• energy-efficiency or fuel-efficiency standards directlyaffect manufacturers.

Industry groups–in particular, large producers and users offuel–are also likely to focus their efforts on the allocation ofcarbon-reduction responsibilities, whatever the instrument. If asystem of emissions standards is put into place, for example,existing firms will benefit if tighter standards are imposed onnew sources, as has happened in a number of countries. Underan emissions tax, firms are likely to seek tax credits, differen-tial tax rates, or exemptions to relieve their tax burden. In a sys-tem of tradable permits, firms are likely to support the freeallocation of permits to participants, rather than to sell them atauction or distribute them to the public (for subsequent sale tofirms). For project-based mechanisms–CDM and JI–theywould favour leaving much of the initiative with the privatesector (Jepma and Van der Gaast, 1999). Industries that standto profit from GHG abatement, including renewable energysources, are likely supporters of climate policies (Michaelowaand Dutschke, 1999a, 1999b).

From a political standpoint, the success of such efforts at thedistribution of the burdens (or rents) is likely to depend on thepolitical saliency of climate change policy. Taxpayers andorganized “public-interest groups” are likely to oppose alloca-tion schemes that benefit firms and/or benefit existing firms atthe cost of the newcomers, thus reducing the scope for compe-tition. If such groups wield clout, and if public interest in cli-


mate policy is high, then mechanisms that appear to benefitpolluters at the expense of the public are less likely to be imple-mented.

In contrast, some environmental organizations have notopposed the allocation of rents to industry, recognizing thatfree allocation of permits may be the most likely path to imple-menting emissions reduction in some countries. Such conces-sions on allocation of rents to the industry have allowed thesegroups to secure other goals in return, such as continuous emis-sions monitoring–the US Acid Rain Program is a good exam-ple (Kete, 1992; Svendsen, 1999). In summary, allocationschemes favourable to industry appear likely in practice,because the question of distribution is central to industry,including industries that will profit from climate policy, but itis only of secondary importance to environmental groups thatdo not support free allocation and to other groups that seek toreduce GHG emissions. In the US Acid Rain Program, forexample, sulphur dioxide (SO2) emissions allowances worthabout US$5 billion per year were allocated free to electric util-ities, in part because of interest group politics (Joskow andSchmalensee, 1988).

Although the “supply side” is heterogeneous across nations, itis likely that some governments will favour policies that raiserevenue while others will be more concerned with the distrib-ution of costs across sources, regardless of the revenue impli-cations.

6.2 National Policies, Measures, and Instruments

Before policies and measures that aim to reduce, or removebarriers that hamper, GHG emissions or enhance sequestrationby sinks are analyzed, it is necessary to understand the sub-stantial impact that other policies (such as the structuralreforms of trade liberalization and liberalization of energy mar-kets) have had on GHG emissions in several developing coun-tries, economies in transition (EITs), and some developedcountries. These policies, sometimes coupled with macroeco-nomic, market-oriented reforms, set the framework in whichmore specific climate policies would be implemented.Therefore, to assess correctly the feasibility of any particularpolicy, it is important to understand this new policy context.The effect of these reforms on energy use and GHG emissionsis not clear a priori. Impacts can differ widely among coun-tries, depending on implementation strategies and the existenceof other regulatory policies designed to prevent the undesiredeffects of free market operation in the presence of externalities,information, and co-ordination problems.

6.2.1 Non-Climate Policies with Impacts on GreenhouseGas Emissions

6.2.1.1 Structural Reform Policies

During the 1990s, several countries, especially EITs and devel-oping countries, implemented drastic market-oriented reformsthat have had important effects on energy use and energy effi-ciency, and therefore on GHG emissions.12 Most countrieshave undergone what has been called the first generation ofstructural reforms: trade liberalization, financial deregulation,tax reform, privatization of state-owned enterprises, and open-ing the capital account as part of a strategy to attract foreigninvestment. Some countries have also implemented macroeco-nomic stabilization packages that include fiscal discipline,independence of monetary policy from the public sector, andexchange rate unification.

The two largest countries in terms of population and coalreserves, China and India, have also started to reform their eco-nomic systems towards a more free-market orientation,although at a slower pace than many other countries. Since1978, energy use in China has increased, on average, 4%/yr.However, the energy–output ratio in China fell 55% between1978 and 1995.13 Garbaccio et al. (1999), using input–outputtables, found that most of this reduction arose from technicalchange, a result supported by other studies (Polenske and Lin,1993; Sinton and Levine, 1994). An increase in energy-inten-sive imports has also led to decreased energy use per unit ofGDP. Others have attributed the reduction to sectoral shifts inthe composition of output (Smil, 1990; Kambara, 1992). Asreform-induced changes aimed at increasing GDP mayincrease the use of energy, the net effect on GHG emissions ofstructural reform in China is an empirical problem that dependson the choice of development strategies, technologies, andcomplementary policies.

Future economic growth in all countries may be accompaniedby increases in GHG emissions. Even if economic growthincreases energy efficiency (both in terms of production andconsumption), the scale effect may dominate and GHG emis-sions may rise, depending on the extent to which other policiesand measures are implemented to curb emissions (Fisher-Vanden, 1999).


12 For a description of the main reforms implemented in LatinAmerica see Lora (1997) and for EITs see Chandler (2000).

13 Energy-output ratios discussed here require a caveat about China’sGDP statistics. China’s energy consumption in 1997 and 1998decreased 0.6% and 1.6%, respectively, and its energy intensity dras-tically declined 80% from 1985 to 1998. Many analysts consider sta-tistics on Chinese GDP to be speculative (IEA, 1998b).

6.2.1.2 Price and Subsidy Policies

Price signals can only influence demand and supply if theyactually reach economic agents and if those economic agentshave the opportunity to respond to them. In Russia, energyintensity increased by 30% between 1990 and 1998, while ener-gy prices also increased tremendously (IEA, 1997b, p. 50).14

Experience shows that it takes time for economic agents toadjust their behaviour to new price signals, not only because ofcapital stock turnover, but also because consumers often do nothave an accurate knowledge of their energy consumption, or thetechnical capacity to reduce it. Various types of energy marketreforms and the pace of energy price reforms are designed tocreate and clear channels for market signals to work.

It is a difficult policy challenge, and therefore a time-consum-ing process, to bring prices into line with real costs. This is trueboth in developing countries, where the poor pay a high costfor low-quality energy services (or a low cost that is heavilysubsidized) and in developed countries. Although data on ener-gy subsidies are incomplete, partly because such support is dif-ficult to identify and measure, some evidence indicates thatsubsidies on coal production, including transfers from bothconsumers and taxpayers, are declining in a number of OECDand developing countries. Recent data suggest that the totalproducer subsidy estimates for the coal production ofGermany, UK, Spain, Belgium, and Japan, which amounted toover US$13 billion at the beginning of the 1990s, had declinedto less than US$7 billion by 1996 (OECD, 1998a, 1998b). Inaddition, case studies in the energy supply sector identified thefollowing areas for potential subsidy reforms: removal of coal-producer grants and price supports; reforming subsidies toinvestment in the energy supply industry; and regulatoryreform to eliminate non-tariff barriers to the energy trade(OECD, 1997a, 1997b).

An IEA (1999b) analysis of fossil energy subsidies in China,Russia, India, Indonesia, Iran, South Africa, Venezuela, andKazakhstan–which accounted for 27.5% of the world’s totalenergy demand in 1997–claimed that removing such subsidieswould lower CO2 emissions by 16% in these countries,amounting to a 4.6% reduction in global emissions.15

The transport sector–to give an important example–is anothersector that receives subsidies detrimental to the environment.Transport is indirectly subsidized through infrastructurefinancing and through tax benefits, which enhance the trans-port volume. According to Shelby et al. (1997), energy subsi-dies were higher than those to transportation for the OECDarea. They also found for the USA that larger CO2 savingscould be achieved through reform of indirect rather than directtransport subsidies, such as free parking and supporting thehighway infrastructure. Reform policies to internalize externalthe effects will, according to one study, probably lower sector-wide emissions by 10–15% (OECD, 1997c).16 These findingsare in line with the results from other work on internalizing theexternal cost of transportation (ECMT, 1998). The same stud-ies also indicate that local communities can better carry outpolicy reform in the transport sector, because transport subsi-dies may originate at the local level and local communities aremore likely to value other ancillary benefits through policyreform (OECD, 1997c; ECMT, 1998). The transport sector isonly mentioned as an example, because it is responsible for alarge share of the national emissions in many countries.17

6.2.1.3 Liberalization and Restructuring of Energy Markets

Liberalization of energy markets gives the suppliers greaterfreedom in the extraction, processing, generation, transporta-tion, and distribution or supply of energy products and the con-sumers greater freedom to choose from different providers(WEC, 1998). In the electricity subsector, the separation oftransmission from generation followed the realization that onlytransmission is a natural monopoly (Hunt and Shuttleworth,1996). Recently, various measures have been taken to liberal-ize energy markets. The EU, for instance, adopted rules to lib-eralize its electricity market (IEA, 1997a), which became oper-ational early in 1999 (although some EU countries, such as theUK, had started earlier). It is expected that this will be fol-lowed soon by rules regarding a liberalization of the natural


14 The major reasons for such growth were: a shift from an energy-intensive industrial structure to an even more energy-intensive indus-trial structure through maintaining the competitive advantages ofenergy and raw materials production in parallel with a sharp reductionof production in less energy-intensive industries; reduced share ofproduction-related energy consumption at the expense of heating,ventilation, and air conditioning (HVAC) related energy consumption;reduced GDP, industrial production, and industrial energy consump-tion with the background of a relatively stable energy consumption inthe residential sector; lack of control and metering devices; non-pay-ment problem, which appeared partly as a reaction to the sky-rocket-ing growth of energy prices; weak capital markets and high interestrates to attract capital for energy-efficiency improvement projects (seeBashmakov, 1998).

15 The percentage reduction in energy consumption was calculated byadding the gross calorific value of the reductions of the different fuelsunder consideration and expressing the sum as a percentage of totalprimary energy supply (TPES). As the calculations in this study didnot take into account the refinery sector (a 5% reduction in gasolineuse can amount to a reduction in TPES of more than 5%), the numberthus derived constitutes a lower bound to the true reductions in ener-gy consumption. Some country experts strongly criticized themethodology and quantitative results of the study (Bashmakov,2000).

16 In this regard the time element could be crucial. In fact, during thetime in which prices adjust, transport volumes may grow, but growthmay be retarded. Additional research is needed to establish these find-ings.

17 Other sectors, including electricity generation, mining, cement,agriculture, and forestry, can also involve significant GHG emissionsbut benefit from subsidies that increase emissions.

gas market.18 In the USA, as a result of changes in policies atboth federal and state levels, the generation and sales of elec-tricity are being opened to competition. Liberalization of theenergy markets in developing countries and EITs has, in manycases, been part of the macroeconomic restructuring in thesecountries. Both in Africa and Latin America, one of the maindriving forces behind the reform of the power sector is toattract private capital to expand and improve the sector.

Although these policies are mainly inspired by the wish toincrease competition in the energy and power markets, theycan have, through their impact on the choice of productiontechnology, significant emissions implications. Energy restruc-turing may include regulation of the transmission monopoly,environmental cost internalization, and system-benefit charges(SBCs; see Boxes 6.6 and 6.7). Several studies have examinedthe effects on GHG emissions of the restructuring of the elec-tricity industry, but the issue is far from resolved. Indicationsare that the impacts can be either positive or negative (IEA,1998b). The degrees of the environmental effects of liberaliza-tion of the electric utility industry are case specific and dependon pre-existing circumstances (e.g., fuel mix, vintage of plant,taxation schemes, and other factors). They also depend on suchfactors as national endowment of resources, the fuel mix, thevintage structure of generation capacity, scope for restructur-ing, and the size and speed of policy reform (OECD, 1999). Inshort, energy-sector structural reform cannot, in itself, guaran-tee a shift towards less carbon-intensive power generation.19

On the whole, however, it may provide for a more economi-cally driven behaviour that would be more responsive to pricesignals placed on GHG emissions.

Finally, the impacts of energy-sector structural reforms can beenhanced if appropriate additional policy measures are taken,20

such as demand-side management (DSM). An example of thelatter is the British Energy Savings Trust, which was set up 3years after restructuring the UK energy markets, in 1992, tofinance DSM programmes run by regional electric companies.

According to an IEA study (IEA, 1999a), in the UK energy sec-tor the structural reforms in the electricity, coal, and gas supplysectors reduced the share of electricity generated from coalfrom 65% in 1990 to 35% in 1997. This resulted from closureof older coal-fired plants and the construction of combinedcycle gas turbines. In countries where the electricity systems

are largely based on non-fossil fuels, like Brazil, Norway,Sweden, and Switzerland, competition without environmentalregulation may well lead to increased CO2 emissions, as gas-fired power stations often will be the most economically attrac-tive option for the development of new capacity.21

In Japan, after liberalization of the power-generation marketseveral independent power producers entered it. However,around 85% of their fuels were coal and residual oil that,though inexpensive, emit more CO2 per unit of power generat-ed. With the liberalization of the retail market, adopted in 2000for large power users, it is possible that the construction of anatomic power or liquefied natural gas (LNG) plant, both ofwhich require a longer lead time and a huge investment, willbecome difficult. This may lead to adverse effects in terms ofCO2 emissions (Sagawa, 1998).

Several studies in the USA have tried to quantify the potentialimpacts of restructuring the electricity industry on GHG emis-sions (see Lee and Darani, 1995; Rosen et al., 1995; US FERC,1996; Palmer and Burtraw, 1997). The FERC study suggeststhat there would be no significant increase in total CO2 andnitrogen oxides (NOx) emissions. The other studies, however,suggest that the impact of a more open transmission grid onCO2 and NOx emissions could be substantial. A more recentstudy by the US Department of Energy’s (DOE) Office ofPolicy found that the restructuring envisioned under theComprehensive Electricity Competition Act (CECA) will leadto 145–220 megatonnes (Mt) less CO2 emissions in 2010 thanwould have occurred in the absence of an explicit policy toreduce CO2 emissions from the electricity sector (US DOE,1999).22

There is a growth in literature that focuses on the impacts ofliberalization and restructuring of energy markets on the keytechnologies of interest in the context of GHG reduction, suchas energy efficiency, co-generation, and renewables.23


18 An EU Directive on Natural Gas was adopted by the EuropeanCouncil of Ministers in May 1998 after publication in mid-1998;member states will have 2 years to implement the Directive.

19 While it led to reduced emissions in some countries, such as the UK(Fowlie, 1999), it had the opposite effect in others, such as Australia.

20 Another example is how liberalization of energy markets can reducemitigation costs, especially when permit trading is not allowed, inso-far as, for instance, electricity trade makes it easier to fulfil mitigationcommitments (see also Hauch, 1999).

21 In this regard, in Sweden the increase in carbon intensity was morethe result of the political choice to phase out some nuclear powerplants than of a link to the creation of an exchange. More generally, itmay well be that the long-term impact of the international powerexchange between Norway and Sweden will be that gas-fired powerplants are added to the Nordic electricity system, causing coal-firedgeneration to decline. For some general information on the relation-ship between market deregulation and national mitigation commit-ments, see also Baron and Hou (1998).

22 The DOE study incorporated policy proposals such as increasingthe renewable-energy portfolio standards (RPSs) and removing barri-ers to the use of combined heat and power technologies where they areeconomical. In response to calls from environmentalists to reduce thepotential impacts of restructuring the electricity industry, some coun-tries initiated specific policies aimed at increasing the role of renew-able energy in the electricity generation mix (Mitchell, 1995b, 1997;Wolsink, 1996; Wiser, 1997, 1999; Wiser and Pickle, 1997; Novem,1998; Haddad and Jefferis, 1999; Wiser et al., 1999).

6.2.2 Climate and Other Environmental Policies

Section 6.2.1 sets the general policy context in which any envi-ronmental policy will operate. This section focuses on specificpolicies to address climate change. The various policy instru-ments are assessed generically. In other words, there is not asector-specific focus, because it is beyond the scope of thischapter. This may create some bias insofar as most sector-spe-cific policies are technology oriented and of the command-and-control type.

6.2.2.1 Regulatory Standards

Regulatory environmental standards set either technology stan-dards or performance standards, enforceable through fines andother penalties24 (voluntary standards are discussed in Section6.2.2.4). They may attach to a product, a line of products (e.g.,US Corporate Average Fuel Economy (CAFE) standards), orthe provision of a service (e.g., Japan requires that firmsemploy an energy manager).25 In this chapter regulatory stan-dards are distinguished from economic or market-based instru-ments (taxes and fees, permits, subsidies). Although all regula-tory standards have consequences upon economic decisionmaking, they differ from market-based instruments, whichoperate by directly changing relative prices rather than byspecifying technology or performance outcomes.

Regulatory standards can be effective policies to address mar-ket failures and barriers associated with information, organiza-tion, and other transactions costs. They also are widely used torequire actors to account for environmental externalities and, ifcontinually modified to account for technical progress, theycan provide dynamic innovation incentives (see Section 6.5.3).The principal sources of inefficiency associated with some reg-ulatory standards derive from too narrow specifications of uni-form behaviour in heterogeneous situations, weakness in con-trolling aggregate levels of pollution, and relatively more diffi-cult application to products other than component or turnkeytechnologies. By requiring a certain level of performance with-

out specifying how it should be achieved, performance stan-dards generally reduce losses through inflexibility when com-pared to technology standards.

On the whole, energy efficiency standards have proved to be aneffective energy conservation policy tool. Energy efficiencystandards are widely used in over 50 nations and the number ofstandards is still growing.26,27,28 For appliance standards enact-ed in the USA, cumulative energy savings in 1990 to 2010 areestimated at 24 etajoules (EJ), consumer life-cycle costs sav-ings at US$46 billion, and emission reductions at about400MtCO2. For an early estimate, see McMahon (1992). Theintroduction of refrigerator and freezer standards in the EU isestimated to generate 300 TeraWatt hours (TWh) of cumulativeelectricity savings during 1995 to 2010 (Lebo and Szabo,1996). Similar measures in Central and Eastern Europe areexpected to save 60 TWh energy and to reduce emissions by 25MtCO2 (Bashmakov and Sorokina, 1996). In Japan, the lawconcerning the rational use of energy was strengthened on 1April 1999 and is expected to reduce, in combination with theindustries’ voluntary actions plan, a maximum of 140 MtCO2in industry, transportation, and other sectors in total(Yamaguchi, 2000). Energy efficiency standards are especiallyeffective in countries with high and growing appliance owner-ship and in countries in which consumers’ energy awareness islow because of historically low energy prices.

The development of an effective regulatory standard requiresnational and, potentially, international, leadership to balancethe interests of manufacturers, consumers, environmental non-government organizations (NGOs), and other interest groups,while creating sufficient societal support and incentives forsuccessful implementation. While decisions to introduce regu-latory standards are commonly made by legislatures, the devel-opment and implementation of standards over time is often leftto a less transparent public administration. Although theenforcement and monitoring of all policy instruments is costly


23 See Mitchell (1995b); Weinberg (1995); Boyle (1996); Lovins(1996); Nadel and Geller (1996); Owen (1996); Brown et al. (1998);Eyre (1998); Patterson (1999).

24 There is no general agreement on terms by which regulatory stan-dards are classified. In the USA, technology standards are often calledcommand-and-control standards because they dictate particular tech-nologies or best practices that limit the range of compliant behaviours.In other nations, command and control normally refers to all regula-tory standards because they command behaviour and control compli-ance therewith.

25 Mandatory standards are put in place by either specific legislationor government regulation. See, for instance, the ComprehensiveNational Energy Policy Act (USA, 1992), versus the EnergyConservation in Buildings Requirement for Thermal Performance andHeat–Water–Power Supply (Moscow City Government, 1999).

26 In the USA in 1997 standards set for appliances are estimated tocover 75% and 84% of primary and delivered energy, respectively, inthe residential sector. Similarly, it is estimated that standards covered49% of both primary and delivered commercial energy use in 1997(EIA, 1999).

27 Technological progress provides a basis for regular updates of effi-ciency standards. In Russia, for instance, 1976 standards for refriger-ators were improved by 50% in the 1980s and then in 1991 by anadditional 50%. As a result, energy consumption of new unitsdecreased by a factor of three (Bashmakov and Sorokina, 1996). TheAmerican Society of Heating, Refrigeration, and Air ConditioningEngineers updates its codes for residential and commercial buildingson average every 10 years.

28 In France, successive building codes in the residential sector alonehave generated 75% of the total energy savings over past 20 years.After building codes were set in 1974 they were made stricter in1982, 1988, and 1998 (IEA, 1996, p.38).

and subject to failures, including discriminatory treatment andcorruption, social science literature that examines the imple-mentation of regulatory standards is more extensive.

Recent literature indicates that regulatory standards often pre-cede market-based instruments and build institutional capacityin policy evaluation, monitoring, and enforcement (Legro etal., 1999). This is especially true in developing countries thatlack both trained personnel and the financial resources toimplement market-based instruments.29 Technology standardshave provided the initial training ground for public officialsunfamiliar with any approach to environmental regulation.Russell and Powell (1996) found that developing countrieswith a better institutional capacity developed through experi-ence with regulatory standards generally are more successful inimplementing market-based environmental policies than lesswell-equipped countries. Cole and Grossman (1998) suggestthat when historical, technological, and institutional contextsare taken into account, technology standards are efficient in theinitial stages of environmental policy development.

The use of regulatory standards to force the internalization ofenvironmental costs has initial distributional consequences dif-ferent from those of environmental taxes or subsidies.30

Regulatory standards reduce economic benefits previouslyshared by consumers, capital, and labour only to the extent ofcompliance costs and/or output foregone. Unlike environmen-tal taxes or auctioned permits, regulatory standards do notextract the value of environmental costs on inframarginal pro-duction that continues after the policy is mandated.

Regulatory standards may also be used to correct barriers thatarise from information failures and can yield net benefits tosociety if the costs associated with the regulation are less thanthe losses due to informational barriers.

6.2.2.2 Emissions Taxes and Charges

An emission tax on GHG emissions requires domestic emitters topay a fixed fee, or tax, for every tonne of CO2eq of GHG releasedinto the atmosphere. Such a fee would encourage reductions inGHG emissions in response to the increased price associatedwith those emissions. In particular, measures to reduce emissionsthat are less expensive than paying the tax would be undertaken.

Since every emitter faces a uniform tax on emissions per tonneof CO2eq (if energy, equipment, and product markets are per-fectly competitive) this would result in the least expensivereductions throughout the economy being undertaken first(IPCC, 1996, Section 11.5.1; Baumol and Oates, 1988). In thereal world, markets, especially energy markets, deviate fromthis ideal, so an emissions tax may not maximize economicefficiency. Rather, the efficiency of an emissions tax should becompared with that of alternative policy measures. Criteriaother than efficiency, such as distributional impacts, are likelyto influence the design of the emissions tax where this is thechosen policy. Although equity considerations could be, in the-ory, better addressed through other redistribution mechanisms,in practice most energy and emissions taxes apply differentialtax rates to different sources.

An emissions tax, unlike emissions trading, does not guaranteea particular level of emissions. Therefore, it may be necessaryto adjust the tax level to meet an internationally agreed emis-sions commitment (depending on the structure of the interna-tional agreement; see Section 6.3). The main economic advan-tage of an emissions tax is that it limits the cost of the reduc-tion programme by allowing emissions to rise if costs are unex-pectedly high (IPCC, 1996, Section 11.2.3.1; see also Section6.3.4.2).

An emissions tax needs to be adjusted for changes in externalcircumstances, like inflation, technological progress, andincreases in emissions (Tietenberg, 2000). Inflation increasesabatement costs, so to achieve a target emission reduction thetax rate needs to be adjusted for inflation. Fixed emissionscharges in the transition economies of Eastern Europe, forexample, have been significantly eroded by the high inflation(Bluffstone and Larson, 1997). Technological change general-ly has the opposite effect, reducing the cost of making emis-sions reductions. Thus, technological change generally increas-es the emissions reductions achieved by a fixed (real) tax rate.New sources increase emissions. If the tax is intended toachieve a given emissions limit, the tax rate will need to beincreased to offset the impact of new sources (Tietenberg,2000).

Implementation of a domestic emissions tax touches on manyissues (Baron, 1996). Policymakers must consider the collec-tion point, the tax base, the variation or uniformity among sec-tors, the association with trade, employment, revenue, or R&Dpolicies, and the exact form of the mechanism (e.g., an emis-sions tax alone or in conjunction with other policy measures).Each of these can influence the appropriate design of a domes-tic emissions tax.

6.2.2.2.1 Collection Point and Tax Base

Since GHG emissions caused by the combustion of fossil fuelsare closely related to the carbon content of the respective fuels,a tax on these emissions can be levied by taxing the carboncontent of fossil fuels at any point in the product cycle of the


29 This also applies to current climate policy. Under certain circum-stances it is preferable to adopt a more intensive regulatory standardsphase by financing capacity building and hands-on-experience in theflexible instruments for administrators in developing countries(Montero, 2000c). The Activities Implemented Jointly (AIJ) pilotphase might be considered a step in this direction.

30 Regulatory standards reverse the distributional effects of efficientsubsidies in that the incremental costs of regulation are borne not byproducers, but by the subsidy-financing tax base or those consumerswho must cross-subsidize the environmental goods (see Section6.2.2.6).

fuel (EIA, 1998).31, 32, 33 A producer–importer tax on the car-bon content of fossil fuels, coupled with a crediting scheme forexports and non-combustion end-uses, closely replicates theeffect of a direct emissions tax on end-users (CCAP, 1998).Further, by focusing on producers and importers rather thanend-users, the number of regulated entities is dramaticallyreduced. Fewer regulated entities lead to substantially lowermonitoring and enforcement costs. Modelling studies showthat taxing fossil fuels on a basis other than carbon content–forexample, energy content or value–also reduces CO2 emissions,but usually at a higher cost for a given emissions reduction tar-get (IPCC, 1996, Section 11.5.1).34

6.2.2.2.2 Association with Trade, Employment, Revenue, andResearch and Development Policies

In an open economy, countries are often concerned about theimpact of emissions taxes on tradable goods sectors (OECD,1996a; IPCC, 1996, Section 11.6.4). In practice, therefore, cur-rent carbon taxes generally tend to have a lower rate on thetradable goods sectors, especially when they are energy inten-sive. When some trading partners do not undertake emissionsreductions, for example, domestic emissions taxes on carbon-intensive tradable goods might simply shift production tocountries without such taxes. One solution is corrective taxeson imports and exports (OECD, 1997d). If this option is notavailable (see Section 6.4.2), an emissions tax that is differen-tiated among various sectors in the economy may be preferred(Hoel, 1996). Another solution, which Böhringer andRutherford (1997) find to be more efficient, is sector-specificwage subsidies to protect jobs in the carbon-intensive tradablegoods sector.

Opposition to increased environmental regulation in generaloften centres on concerns that firms might relocate and/or peo-ple might lose their jobs (Rosewicz, 1990).35 Emissions taxesare particularly vulnerable to this criticism since they requirefirms not only to pay abatement costs, but also taxes on theirunabated emissions (Vollebergh et al., 1997). Several recentpapers, however, argue that emissions taxes are more cost-effective than direct regulation and may even lead to higheremployment (Wellisch, 1995; Hoel, 1998). The intuition is thatthe right to emit pollution constitutes a rent. With mobile cap-ital markets, part of that rent accrues (inefficiently) to ownersof capital unless it is taxed (Schneider, 1998). By using the taxrevenue to offset labour taxes, employment can be higher thanin similarly designed policies using direct (technology) regula-tion (Hoel, 1998; see also Section 6.5.1). Chapters 8 and 9 referto various sources corroborating the evidence that using emis-sions and/or energy taxes to reduce distortionary labour taxestends to increase employment.

Even with an efficient outcome, the immediate profit losses tofirms under an emissions tax might be considered “unfair” tofirms in carbon-intensive industries. In that case, a portion ofthe tax revenue can be returned to firms (lump sum) to com-pensate them for lost profit without a loss of efficiency.Bovenberg and Goulder (1999) estimate that only 15% of therevenue from an emissions tax would need to be refunded toindustry to maintain existing profit.

In addition to reducing emissions and raising revenue, a carbontax also influences innovation. This occurs alongside any dis-tinct R&D policies that are undertaken (see also Section6.2.2.6). Early work in this area indicated that auctioned per-mits would provide the largest incentive to innovate, followedby emissions taxes and then permits allocated free (Millimanand Prince, 1989). More recent work demonstrates that with alarge number of competitive firms and imperfect R&D mar-kets, taxes may induce more innovation than auctioned per-mits, although the welfare effects remain ambiguous (Fischeret al., 1998). The incentive for innovation is therefore a neces-sary design consideration (Grubb et al., 1995; see Section6.2.2.6). It has been suggested in this regard that the targettedrecycling of emissions taxes that support renewable energy andenergy efficiency activities may offer specific benefits (seeSections 6.2.2.6, 6.5.1, 6.5.2; IPCC, 1996).

In practice, both energy and carbon taxes have already beenadopted as responses to commitments under the UNFCCC. TheEuropean Commission (EC), for instance, has issued severaltax proposals designed to reduce emissions of CO2 from fossilfuel use. For example, Finland, Netherlands, Denmark,


31 Empirical work suggests that to focus on all six gases of the KyotoProtocol (CO2, CH4, N2O, SF6, PFCs, HFCs) and not just the carboncontent of fuels reduces compliance costs substantially (Reilly et al.,1999).

32 This assumes that “carbon removal and disposal” strategies (e.g.,removing CO2 from stack gases and sequestering them in geologicalformations or land use change involving afforestation and reforesta-tion) receive payments equivalent to the tax rate per tonne CO2eqsequestered. It also assumes that non-energy GHG emissions are alsosubject to the tax or to policies for which the marginal abatement costis equal to the tax rate.

33 One aspect that is also relevant is taxing net emissions versus grossemissions. Land use changes are included in the Kyoto Protocol. Anational Computable General Equilibrium (CGE) model in whichemissions from the use of timber and carbon accumulation in the for-est are taken into account, thus calculating net emissions, is given byPohjola (1999). If net emissions are taxed, Pohjola (1999) finds thatthe carbon tax needed to reduce net emissions by the same amount asemissions from fossil fuels is significantly lower.

34 Energy taxes may be more efficient than taxes on carbon alone ifthere are negative externalities unrelated to CO2 associated with theenergy services delivered.

35 A 1997 OECD study (OECD, 1997d) suggests that the evidencethat more stringent environmental regulation is reflected in the pat-tern of international trade in goods produced by traditionally pollut-ing activities is not yet clear. This conclusion could change, however,if energy taxation or any comparable measure is introduced at a largescale.

Sweden, and Norway all have energy taxes based in part oncarbon content (Speck, 1999; see Section 6.1.3). Other coun-tries that have recently introduced carbon or energy taxes tohelp achieve their climate change commitments includeSlovenia, UK, Italy, Germany, and Switzerland. France is alsoconsidering increasing energy taxes on industry for the samepurpose. None of these countries have been able to introduce auniform carbon tax for all fuels in all sectors, because unilater-al nature policies raise. In most cases for which an energy orcarbon tax is implemented, the tax is implemented in combi-nation with various forms of exemptions (e.g., rebates, VAs).

6.2.2.3 Tradable Permits

A country committed to a limit on its GHG emissions can meetthis limit by implementing a tradable permit system that direct-ly or indirectly limits emissions of the domestic sources cov-ered by the commitment. The large number and diverse natureof the sources covered by national limits on GHG emissionsraises issues of how to assign permit liability. If permit liabili-ty is imposed at the point of release to the atmosphere, a so-called “downstream” system, individual vehicle owners andhouseholds would have to participate.

Some emissions, such as HFCs, sulphur hexafluoride (SF6),and energy-related CO2, can be controlled indirectly, with a so-called “upstream” system, by limiting substances that ulti-mately result in GHG emissions (see, e.g., IPCC, 1996; Bohm,1999).36 Since energy-related CO2 emissions are linked to thecarbon content of fossil fuels, the system could be implement-ed by requiring fossil fuel producers and importers to hold per-mits equal to the carbon content of the fuels sold domestical-ly.37 Permit liability for energy-related CO2 emissions could beimposed at any point in the fossil fuel distribution chain and atdifferent points for different categories of sources, for exampledownstream for large industrial sources and on petroleum com-

panies for transportation fuels.38 Industrial non-energy sourcesof GHG emissions also lend themselves, at least partially, toinclusion in a tradable permit system (Haites and Proestos,2000).

Permits equal to the emissions limit are distributed (gratis orby auction, usually to permit-liable entities) and each permit-liable entity is required to hold permits equal to its actual GHGemissions or actual sales of regulated substances as appropri-ate. Permits may be traded, at least domestically and at leastamong permit-liable entities. Such a tradable permit system iswell known from the literature to be cost-effective if transac-tions costs are not prohibitively high and if there are no signif-icant imperfections in the permit market and other markets per-taining to the emitting activities (see IPCC, 1996, p. 417).39

Some sources of GHG emissions, such as methane emissionsfrom livestock, as well as small sources, are very difficult toinclude in a tradable permit system because it is difficult tomeasure actual emissions (or an accurate proxy for actualemissions). In practice, then, the emissions cap for the tradablepermit system is less than the national emissions limit andsome sources need to be addressed by other policies.40 Forexample, a government that takes part in an internationalagreement, such as the Kyoto Protocol, may establish an emis-sions cap for the tradable permit system on the basis of the ini-tial national limit or the ex post limit, taking into account its nettransfers under the Kyoto mechanisms.41

With a significant number of permit-liable entities it should bepossible to establish market institutions that have low transac-


38 See NRTEE (1999) for a comprehensive overview of options forthe design of a domestic GHG tradable permit system. Remember thatthe liable point may differ from the point of allocation. See Matsuo(1999) and Iwahashi (1998) on this.

39 Tradable permits have been used to implement a cap on SO2 emis-sions by electricity generators in the USA and on NOx and SOx emis-sions by large sources in the greater Los Angeles area (the RegionalClean Air Incentives Market (RECLAIM) Programme; e.g.,Schmalensee et al. (1998); Stavins (1998a)).

40 NRTEE (1999) suggests that coverage for different designs canrange from 30% to over 90% of total emissions. Given a satisfactorysolution to the monitoring problems, cost-effectiveness is improvedby including as large a share of total emissions as possible in the trad-able permit system.

41 The national government could choose to be a net buyer or sellerusing the Kyoto mechanisms. To achieve compliance, the cap for thedomestic trading system should reflect the national limit after adjust-ment for these international transfers. Whether the domestic cap isbased on the initial commitment (no government transfers under themechanisms) or the ex post limit, permit-liable entities could beallowed to acquire quotas under the Kyoto mechanisms, if allowed bythe rules governing those mechanisms, for use towards compliancewith their obligations under a domestic tradable permit system.

36 HFCs and SF6 are manufactured gases used in a variety of applica-tions and ultimately escape to the atmosphere. Limiting sales of thesegases in the country effectively limits the subsequent emissions. Cost-effectiveness then requires that the prices of the regulated substancesrise to reflect the social marginal cost of abatement (see Section6.4.1), so that the sources have the correct incentive to implement theappropriate abatement measures.

37 Virtually all of the carbon content of fossil fuels is converted to CO2upon combustion. Thus, if there are no commercially viable CO2 cap-ture and sequestration technologies, the CO2 emissions are closelyrelated to the carbon content of the fuel. If CO2 capture and seques-tration is implemented, an upstream system based on the carbon con-tent of fossil fuels could still be implemented, but it should be com-plemented by a system of credits for sequestered CO2. Some fossilfuel is used as a feedstock for products that sequester the carbon for arelatively long time. An upstream system should include provisions toexempt the carbon sequestered in such products. A particular aspectthat can be introduced is to specify a validity period of permits byestablishing gradual devaluation and an expiration date. By introduc-ing this dynamic incentives could be created.

tion costs and that limit the scope for market power.42 The onlysituation in which there might not be enough permit-liable enti-ties is in a small country with an oligopolistic market for fossilfuels and an “upstream” trading system.43 In particular, if anexchange institution is used, transaction costs are likely to besmall and market power (the possibility of one or more marketparties to manipulate market conditions in their favour, or totry to achieve such a result by taking speculative positions) isunlikely to have a noticeable influence on the transaction vol-ume or final market prices (e.g., Smith and Williams, 1982;Carlén, 1999).44 If the domestic tradable-permit system is inte-grated with an IET market (see Section 6.3.1)–which furtherincreases cost-effectiveness–any remaining market power con-cerns are greatly diminished.

Some analysts argue that to allow entities, in addition to per-mit-liable participants, to participate in the market is desirablefor several reasons. It allows the risks of changes in permitprices to be borne by the entities (e.g., private brokerage firms,traders, professional speculators, or arbitrators) best able tobear those risks. It may also improve intertemporal efficiencyif other entities have relevant information not heeded by per-mit-liable participants. The behaviour of participants in thepermit market might need to be supervised in the same manneras in other financial markets, regardless of whether they arepermit-liable or not, to prevent abuses such as insider tradingand efforts to manipulate the market.

Permit prices fluctuate, but this does not mean that prices of theproducts of permit-liable entities fluctuate to the same extent.Crude oil prices change daily, but the prices of various petrole-um products, such as gasoline, are much more stable. Forwardcontracts and options are used to transfer the risks of price fluc-tuations to sources willing and able to bear those risks.45 The

same mechanisms are likely to be used by permit-liable entitiesto deal with the risks of fluctuations in permit prices.

The market value of the permits needed by a permit-liable enti-ty is passed on to customers in the form of higher prices, toemployees through lower wages, to shareholders throughlower returns, and to suppliers through lower prices. To answerhow the costs are shifted to these different groups requires acomprehensive model of the economy with accurate values forrelevant price elasticities. Ultimately, the costs are borne byindividuals, with the impact on a particular person reflectinghis or her role as an employee, investor, and/or consumer ofvarious products.46

Permits can be distributed to permit-liable entities (and/or oth-ers) gratis or by auction.47 Gratis allocation requires a rule fordistributing the permits among the recipients. Since the permitsrepresent an asset transferred to the recipients it can be difficultto find a rule that is considered fair by all. An auction raisesrevenue. All of the revenue could be returned to permit-liableentities, but this needs to be done in a manner that leaves themwith an economic incentive to reduce their emissions. The rev-enue could also be used for a variety of other purposes.Compensation could be provided to industries, whether or notthey are permit-liable entities, or households that bear a dis-proportionate share of the impact. The revenue could also beused to reduce existing distortionary taxes and so reduce thenet cost of the emission reduction policy (see Section 6.5.1).The introduction of an emissions trading programme, like theimposition of any new tax or regulation, imposes adjustmentcosts on the affected entities. This is true whether the permitsare auctioned or distributed gratis. Moreover, some gratis allo-cation rules discriminate against new entrants (IPCC, 1996;Cramton and Kerr, 1998; Zhang, 2000).


42 The number of participants in the trading programme could besmall if a country chooses to make fossil-fuel producers and importerspermit-liable and there are very few such firms. This implies that thedomestic market for fossil fuels is not competitive. If the country cre-ated a competitive market for fossil fuels, the number of permit-liableentities would likely be sufficiently large to create a competitive mar-ket for permits as well. Sweden, which imports all its fossil fuel, hassome 350 fossil fuel importers that are now liable to a carbon tax andthat would be permit-liable should it choose to shift to a tradable per-mit system.

43 Even under such circumstances a competitive permit market couldbe created by restructuring the fossil fuel market.

44 Although the US SO2 allowances are not traded on an exchange,over 9.5 million allowances were transferred between economicallyunrelated parties in 1998 and brokerage commissions for a simpletransaction are approximately 1% of the sale price.

45 For crude oil and natural gas, the options are exchange-traded con-tracts. Such transactions also occur in the SO2 allowance market; theydo not require exchange-listed contracts.

46 This is true regardless of the domestic policy adopted to meet theGHG emissions limit. However, the total cost of meeting the limit,and the distribution of that cost, may differ with the policy adopted(see Section 6.5.1).

47 Auctioned permits are equivalent to a tax, if adjusted with a similarfrequency, and are designed to achieve an equal emissions reductionby the same sources. If, instead, tradable permits are allocated gratisto certain entities, the same distribution is obtained as in the tax caseif the tax revenue is redistributed to these entities in the amount of thewealth of the permits otherwise allocated to them (IPCC, 1996, p.410). To redistribute the tax revenue it is necessary to confirm the totalamount of permits allocated. This means that the taxation system incombination with the revenue redistribution inevitably involves a keydimension of the permit trading system, so that the advantage of thetaxation system in administrative costs diminishes significantly. If thescale of allocation for the permits in gratis is determined on the basisof historical factors, the allocation in gratis does not reduce efficien-cy in emissions reduction. Tax exemption and reduction, however,may reduce or even eliminate incentives for emissions reduction anddepreciate the efficiency factor embraced in the taxation policies,because the scale of reduction or exemption is determined by the cur-rent emissions quantities.

Assuming compliance, permits are a more certain means thantaxes of achieving quantified national emission limits. In addi-tion, a tradable permit system with auctioned permits is morelikely to provide the efficient price signal than a tax rate set bythe government. However, the certainty of achieving the emis-sions levels provided by a tradable permit system incurs thecost of permit prices being uncertain. Some have argued infavour of introducing a trigger price into a permit trading sys-tem to meet this concern, namely the absence of an upperbound on the price and hence on compliance costs (See e.g.,Kopp et al., 1999a). When the permit price reaches the trigger,additional permits are sold by the government to prevent theprice from rising further. Such a hybrid system fails to guaran-tee particular emissions levels, but does limit the economiccost of the programme for its users.48

6.2.2.4 Voluntary Agreements

No international definition of a VA is universally accepted(CEC, 1996; EEA, 1997; OECD, 1998a). VA is used here tomean an agreement between a government authority and one ormore private parties, as well as a unilateral commitment that isrecognized by the public authority, to achieve environmentalobjectives or to improve environmental performance beyondcompliance.49

VAs may take a wide variety of different forms. The large-scaleVAs in the field of GHG mitigation activities in Japan and theNetherlands are referred to in Boxes 6.3 and 6.4. For a descrip-tion of the US “market transformation” type VA and theGerman VAs, see Mazurek (1998) and Storey et al. (1999), andEichhammer and Jochem (1998), respectively. Sometimesthese involve agreements between the government and a set offirms, but in other cases industry associations represent mem-ber firms. Sometimes the agreement only relates to generalissues, such as R&D activities, reporting on emissions, or ener-gy efficiency, but in other cases specific quantified targets,such as emissions targets, are agreed upon. A few VAs arelegally binding once signed, but most are not.50

Although VAs are a relatively new environmental policyinstrument, they are gaining popularity as a tool to cope withenvironmental issues. That in 1996 in the EU alone there exist-ed more than 300 VAs at least suggests this type of policy mea-

sure is administratively and politically feasible, especially if itis used in a policy mix or in new policy areas (OECD, 1998a,p. 102). VAs are political feasible simply because most of theindustries seem to prefer VAs over other tools (Dijkstra, 1998;Svendsen, 1999). VAs may precede more formal arrangements;the vast majority of GHG emissions reductions in the USAcalled for in the US Climate Change Action Plan come, forinstance, from voluntary initiatives to increase energy efficien-cy. However, VAs may not be a satisfactory substitute formandatory efficiency standards (Krause, 1996).

Sometimes the “voluntary” aspect of a VA is questioned, as themain motivation for industries to join the VA was to avoid theimplementation of a carbon and/or energy tax and/or othermandatory policy (Torvanger and Skodvin. 1999, p. 28).Segerson and Miceli (1997) found that the level of abatementunder a VA is closely related to the probability of regulatoryaction in the absence of an agreement.

Proponents of voluntary approaches point to the low transac-tion costs, the merits of the consensus elements in theapproach, and the advantages of leaving the choice of abate-ment measures to the participants. Although free riding is aconcern with VAs, the risk can be addressed through the prop-er design of the VA. Free riding can take place if firms that donot comply or participate benefit from the agreement whilebearing no cost. Governments may encourage participation inVA programmes and discourage free riders by providing incen-tives such as permits to use labels and other marketing claims.As for possible abuse, some or all of the participants may usetheir initiating role in the process to create an agreement thatbenefits them, and hence obstruct real abatement progress. Itcould also involve introducing measures that benefit somefirms, and reinforces their market dominance.

To assess the environmental effectiveness, the trade-offbetween how ambitious the objectives are and how well theyare attained should be recognized. There is a suspicion that ifthe goals are too ambitious, they will not be attained. As mostVAs are non-binding they may not attain ambitious goals(EEA, 1997; OECD, 1998a). VA objectives may be less strin-gent if environmental groups are left out off the negotiationprocess. Since VAs are a relatively new policy instrument tocope with environmental issues, it is too early to determinetheir effectiveness (OECD, 1998a, pp. 78–83).

From a methodological perspective, it is rather complex toassess the effectiveness of VAs because it is difficult to estab-lish a counterfactual.51

Voluntary provisions also may accompany mandatory policies.The Substitution Provision of the US Acid Rain (SO2Emissions Trading) Program is the first example of a voluntary


48 See Kopp et al. (1999b) for a discussion in the context of domesticUS policy; Roberts and Spence (1976) provide a theoretical discus-sion.

49 “For the purpose of this Communication EnvironmentalAgreements … can also take the form of unilateral commitments onthe part of industry recognized by the public authorities” (CEC, 1996,p. 5).

50 In some countries (e.g., Denmark) negotiated agreements areexplicitly linked to favourable treatment under tax regimes.

51 The issue of counterfactual baselines is revisited in Section 6.3.2.3in the context of the Kyoto mechanisms.

compliance provision within an emissions trading regime.53

Voluntary compliance was characterized by adverse selection;units that “opted in” to the programme tended either to havelow emissions below their permitted allocations, or to have lowcosts of abatement (Montero, 1999). While the VA kept aggre-gate costs low, the adverse selection increased aggregate emis-sions (Montero, 1999). This inevitable trade-off betweenadverse selection and cost-savings means that the design ofvoluntary programmes will influence their net emissionsimpact (Montero, 2000a).

The OECD (1998a) noted that no empirical evidence is avail-able on the cost-effectiveness of VAs. CEC (1996), however,argues that the flexibility of VAs provides room for industriesto find the most efficient way to achieve the targets, whichcould be a major advantage. EEA (1997) recently concluded,

after analyzing six case studies of European VAs, that, whilethere was quantitative evidence for environmental improve-ment in most case studies, more sophisticated analysis wouldbe necessary to distinguish between the effects of the VAs andthose of other factors (EEA, 1997, pp. 84–85). In the samestudy it was recognized, however, that in five of the six casesthe interviewed experts felt VAs incurred lower costs thanalternative instruments.

OECD has indicated various conditions under which VAs canbe implemented most effectively (EEA, 1997, p. 15; OECD,1998a):

• clear targets are set prior to the agreement;• the agreement specifies the baseline against which

improvements will be measured;• the agreement specifies reliable and clear monitoring

and reporting mechanisms;• technical solutions are available to reach the agreed tar-

get;• costs of complying with the VA are limited and are rel-

atively similar for all members of the target group; and• third parties are involved in the design and application

of VAs.

The EC, for instance, recommends prior consultation withinterested parties, a binding form, quantified and staged objec-tives, the monitoring of results, and so on.


Keidanren (Japan Federation of Economic Organizations), the largest private and non-profit economic organization in Japan, announcedthe “Keidanren Appeal on the Environment” in 1996, in which concrete courses of action for measures to cope with global warming werespecified. Following the Appeal, 37 trade associations set forth the “Keidanren Voluntary Action Plan on the Environment” in June 1997.Although the above action plan is a unilateral commitment on the part of the industries, it should be considered an environmental agree-ment.52 In fact it constitutes a major component of the Japanese government’s “Basic Principles for the Promotion of Measures Dealingwith Global Warming”; a follow-up survey is to be conducted every year and reported to the government councils, including the IndustrialStructure Council of the Ministry of International Trade and Industry, for third party review.

This action plan, which contributes to meeting the Japanese commitment under the Kyoto Protocol, has as its goal “to endeavour to reduceCO2 emissions from the 28 industrial and energy-conversion sectors to below the levels of 1990 by 2010.” Under a baseline (or business-as-usual) scenario these emissions are estimated to increase by 10%. The 28 sectors represent approximately 76% of CO2 emissions gen-erated by all industry and energy-conversion sectors in Japan, which in turn generated 42% of Japan’s total CO2 emissions in 1990.

Each participating business sector made a social commitment by setting a numerical target (in terms of: size of CO2 or energy con-sumption; emissions or index of CO2 emissions; or energy input per unit output), which was compiled and published by Keidanren.For example, the Japanese Iron and Steel Federation set a target of reducing energy consumption in 2010 by 10% from the 1990 level(57.22kt crude oil).

The second survey, presented just before CoP5, showed that CO2 emissions in fiscal year 1998 were 126MtC, or 2.4% less than 1990and 6% less than 1997 levels. Keidanren stressed that to meet the emissions goal it would:• continue to make annual surveys of emissions by participating associations;• intensify co-operation between the government and other sectors, such as transportation, households, etc.;• promote the construction of new nuclear power plants; and• explore positively the utilization of the Kyoto mechanisms.

Box 6.3. Keidanren Voluntary Action Plan on the Environment (See http://www.keidanren.or.jp/)

52 This point of view is supported by the EC: “For the purpose of thisCommunication Environmental Agreements … can also take the formof unilateral commitments on the part of industry recognized by thepublic authorities” (CEC, 1996, p. 5).

53 The SO2 emissions trading regime has been implemented in twophases. The first phase (beginning in 1995) imposed annual emissionscaps (with trading) on the 263 dirtiest large electricity-generatingunits. The Substitution Provision allowed units regulated only by thesecond phase (beginning in 2000) to voluntarily “opt in” in the firstphase. Owners of the first-phase plants could use these “substitution”units to lower the compliance costs.

6.2.2.5 Informational Instruments

As Chapter 5 shows, information drives decisions. Informationgaps result in uncertainties, risks, and missed opportunities.Poor information is widely recognized as a barrier to improvedenergy efficiency or reduced emissions (Tietenberg andWheeler, 2000). Markets are not always fully informed on thequality of information and application of decision-supporttechnologies. In Russia, for instance, it is estimated that insti-tutional barriers and information limitations result in only 2%

of the market potential to improve energy efficiency actuallybeing realized (Bashmakov, 1998).55

Reliable data are a prerequisite for decision-making. At themicro level, feasibility studies or business plans are used toexplore opportunities to raise energy efficiency and energyproductivity. They are based on metering and energy audits inspecific situations. At the macro level, detailed statistical dataon major aspects of energy consumption are the basis for devel-opment and evaluation of efficiency improvement policies, and


Box 6.4. Voluntary Agreements in the Netherlands

In the early 1990s, the Dutch government entered into agreements with all energy-intensive industries to improve energy efficiency.The purpose was both to improve competitiveness by cutting energy costs and to reduce CO2 emissions. This win–win situation isfavoured by the Ministry of Economic Affairs, which was primarily responsible for the execution of the long-term agreement (LTA)policy. Efficiency is usually defined as the ratio of relevant physical output to primary energy consumed. The target for most sectorsis to improve energy efficiency by 20% in 2000, compared to 1989. Most sectors were audited before entering into an agreement, toensure that the efficiency improvement was feasible. The coverage of industrial energy consumption is high, almost 90% when non-energy consumption is excluded. There is a similar agreement with the horticultural greenhouse sector, which is the second largestenergy-consuming sector after the chemical industry. An intermediate organization co-ordinates the annual monitoring and runs pro-grammes for technological support and R&D. The government publishes results annually. It is expected that, on average, the 2000efficiency target will be reached.54 Based on interviews and analysis, 30%–50% of the efficiency improvement identified is imple-mented because of LTA and related supporting policies (Glasbergen et al., 1997). The results for the LTA sectors in total manufactur-ing industry through 1996 are depicted in Figure 6.1, together with general statistics (Van Dril, 2000).

Figure 6.1: Aggregated results of manufacturing industry LTAs and statistics.

As a general observation, LTA results diverge from the actual average of the entire manufacturing sector. Both the energy and outputindicators show significant deviations. The main explanations for the divergence are, first, that energy-intensive products such as pri-mary materials have grown faster than average production value. In monitoring practice, there may be some bias towards adjustingfor energy-intensive products, to avoid negative effects on efficiency results. A second explanation is that statistics on the chemicalindustries are unreliable and that no insight is provided by the entities responsible for monitoring. For example, no clear informationis available on the share of non-energy consumption and its impact on CO2 emissions.

0.90

0.95

1.00

1.05

1.10

1.15

1.20

1989 1990 1991 1992 1993 1994 1995 1996

index 1989 = 1

CO2 -relevant energy consumption LTA energy consumption

LTA physical production production value

LTA efficiency

CO2 efficiency

Decrease ofcoverage

Materialization

54 Ministry of Economic Affairs, Netherlands (1999): Long-termagreements on energy efficiency, results (published annually).

55 OECD/IEA (1997) includes 47 case studies of successful energy-efficiency improvement projects and policies.

their success or failure (Japan Energy Conservation Center,1997). Comparisons between nations and companies andbenchmarking on energy efficiency indicators also raise aware-ness and allow for better determination of efficiency potentials(see also OECD/IEA, 1997; Fenden, 1998, p. 203; Phylipsen etal., 1998, p. 230; ADEME-European Commission, 1999). Also,improved accessibility to new technology information enhancestechnology transfer. Information-based policies can also beused to reveal low levels of performance.

Policy instruments to improve information are applied on threelevels. First, they are used to raise awareness of climate issues.Governments communicate their targets and policy measuresto the public. The information may influence preferences tocontribute to GHG mitigation. Social marketing is becoming acrucial instrument in creating an appropriate social environ-ment for GHG emissions reduction policies (Legro et al.,1999). Second, governments stimulate research to analyze cli-mate issues and create mitigation opportunities that can bewidely applied. R&D generates new information on possibili-ties and determines the technical potential. Information on theeconomic situation (prices, taxes, interests rates, etc.) in turnconstrains the technical potential to what is commercially fea-sible. Third, information instruments are used to help theimplementation of measures. They can assist the public inmaking the right choices with respect to GHG mitigation.

There are several reasons for using instruments to further infor-mation on climate issues. First, climate change involves com-plex negative externalities, so the process of policymaking withregards to GHG reduction needs broad support and understand-ing. Second, information, once generated, can be widely used,which is regarded as a reason for collective funding of its col-lection, dissemination, and use. Many of the possible ways toreduce GHG emissions are similar all over the world. Marketsfor this information are not yet developed.

6.2.2.5.1 Education Programmes

Energy efficiency centres, government offices, utilities, equip-ment vendors, professional organizations and associations,educational channels, etc., deliver information on GHG reduc-tion. Improved data and metering, energy audits and monitor-ing, workshops and exhibitions, campaigns in the mass media,education and training, efficiency and environmental labelling,publications and databases are all typical instruments used toenhance information dissemination.

Educational and training programmes may improve decisionmaking and can have long-lasting effects. Consumer educationis an important social marketing tool in implementing DSMprogrammes (see Box 6.5).

Information campaigns are used as marketing elements in mostenergy efficiency programmes. Typical examples of such cam-paigns are:

• publications and advertising;

• broadcasting of special programmes on television andradio;

• distribution of special brochures;• creation of special easily accessible databases; and• public awareness programmes, such as “Energy

Conservation Day” and “Energy Conservation Month”,which are implemented on a regular basis at the nation-al level in Japan and South Korea.

Publication of books and periodicals on energy-efficient tech-nologies and systems, and energy efficiency success stories,guidelines, and policies is another powerful information instru-ment.56 Costs of information programmes vary according totheir scale, coverage of specific groups of customers, and useof media.

6.2.2.5.2 Labelling

One instrument that is increasingly applied in the area of envi-ronmental policy is environmental and energy efficiencylabelling. Labelling programmes can be mandatory or volun-tary.57 Mandatory energy efficiency labels have long been estab-


Box 6.5. Public Education Component of Poland EfficientLighting Project (OECD/IEA, 1997, p. 480)

The IFC/GEF Poland Efficient Lighting Project (PELP) wasdesigned to reduce emissions of CO2 and other GHGs emitted byPoland’s electricity sector by stimulating the Polish consumermarket for energy-efficient compact fluorescent lamps (CFLs).The public education component of PELP promoted the CFL sub-sidy programme to the public by providing consumer informationon the benefits of energy-efficient lighting from a trustworthy,non-industry source. The generic PELP advertising bore the logosand endorsement of four respected Polish organizations. ThePELP logo featured in advertisements and on participating prod-ucts, was promoted as a symbol by which consumers could iden-tify energy efficient, high-quality products. PELP organized high-level seminars for lighting professionals on technical and designaspects of energy-efficient lighting. Finally, to educate tomor-row’s consumers on the benefits of CFLs, PELP created an ener-gy-efficiency curriculum for schools, and sponsored an art andessay competition for schools on energy-efficient lighting.

56 The Russian Center for Energy Efficiency, for instance, since 1993has published the “Energy Efficiency” quarterly bulletin. This stimu-lated regional energy-efficiency legislation, policies, and programmesin Russia. The bulletin is available on the Internet at http://www.glas-net.ru/~cenef.

57 Mandatory labelling programmes are under implementation not onlyat a national level (e.g., Energy Guide in the USA), but also interna-tionally, such as “SAVE” in the EU. Voluntary labelling programmeswere also initially launched at the national level, such as “Blue Angel”in Germany and “Power Smart” and “EcoLogo” in Canada, but thensome were internationalized (e.g. the originally US “Energy Star” pro-gramme for office equipment was introduced in Japan).

lished in the USA, Japan, and South Korea, and recently in theEU where they are part of appliance and automobile efficiencylegislation. Labels and marketing may have a pervasive impacton consumers’ behaviour and the introduction of clean tech-nology. Boxes 6.5 and 6.7 provide some examples of suchdevelopments to illustrate how these phenomena work in prac-tice. The strengths of energy efficiency and environmentallabelling are, first, that labels do not distort the market. Second,in many instances they are voluntary for both the producer andthe consumer because the former is free to decide whether ornot to join the system and the consumer is free to decidewhether or not to buy the labelled product. Voluntary labels area non-official instrument, and may be instituted without theusual delays associated with official policymaking. Third,labels are usually based on considerable information exchangeamong the various stakeholders, which may increase the over-all acceptance of the instrument.

This is not to say, however, that energy efficiency and envi-ronmental labelling do not have weaknesses. If all productsare labelled, the consumer must learn how to interpret thelabel (e.g., do higher numerical values indicate a better orworse product?). If products must meet a specified standard toqualify for a label, only part of the market will be covered bythe labelled product. Competing labels for the same product orless reliable labels may easily undermine the trust of the con-sumers in the labelling instrument. This may turn out to be aninherent limitation.

In sum, environmental labels represent an important tool tocreate transparency in markets and thus give orientation to theconsumer. The overall success of this instrument, however,will probably depend on the solution to the following dilemma:if applied too strictly, market coverage may be too low for thelabel to be effective; if applied too leniently, the environmentaleffectiveness may be limited.

6.2.2.6 Subsidies and Other Incentives

6.2.2.6.1 Environmental Subsidies

A subsidy for GHG emissions reduction pays entities a specif-ic amount per tonne of CO2eq for every tonne of GHG reducedor sequestered. Such a subsidy encourages implementation ofmeasures to reduce emissions or enhance sequestration that areless costly than the subsidy.

Under certain circumstances, a uniform subsidy can lead to thesame emissions reduction outcome as an equivalent uniformtax. In theory, in an industry with homogeneous firms, bothtaxes and subsidies (set at the same levels) yield exactly thesame outcome in the short run. In general, a tax is more effi-cient than a subsidy because the subsidy can result in too manyfirms in the industry, and thus an inefficient amount of bothpollution and goods associated with the pollution (Kolstad,2000). This is always the case in the long run because a sub-sidy lowers the average cost of production, while the tax

increases the average cost of production. In the short run, it isalso the case in an industry with heterogeneous firms. A sub-sidy may allow some firms to continue operating that wouldnot continue in the case of a tax (those with average variablecosts above prices). Besides, a subsidy requires that revenue beraised somewhere else in the economy, which can also producedead-weight losses.

An emissions reduction subsidy, like an emissions tax, does notguarantee a particular level of emissions. Therefore, it may benecessary to adjust the subsidy level to meet an internationallyagreed emissions commitment. In addition, criteria other thanefficiency, such as distributional impacts, are likely to influ-ence the design of the emissions subsidy (or the combinationof subsidies and taxes in what is known as fee and/or rebate).The distributional and competitiveness impacts help explainwhy, in practice, some energy and emissions taxes are coupledwith tax exemptions or subsidies. Also, the use of subsidies forenvironmental purposes may cause problems under WTOagreements on subsidies and countervailing measures.

6.2.2.6.2 Research and Development Policies

Technological progress is mainly achieved in the private sec-tor, through learning by doing, incorporating new findingsdeveloped elsewhere into the production process, or throughfirms own R&D activities. A major, and generally increasing,part of funding of R&D expenditures is initiated by and in theprivate sector itself (Table 6.1). Government funding of R&Don energy has historically favoured nuclear and coal technolo-gies (IEA, 1998a; OECD, 1998a). Research on renewableenergy and energy-efficient technologies is gaining ground, butit is still a relatively small portion of R&D budgets in theOECD. This is important when assessing what governmentscan do to promote innovation. Perhaps governments can pro-vide a reliable legal framework to protect research findings in


Table 6.1: Public expenditures as percentage of gross domes-tic expenditures on R&D (1985–1995) (OECD, 1998a)

Country/ region 1985 1990 1995Public % Public % Public % of total of total of total

Overall OECD 43.0 37.8 34.5USA 50.3 43.8 36.1Canada 48.9 44.3 37.7EU 44.4 40.9 33.1UK 42.2 35.5 33.3France 52.9 48.3 –Japan 21.0 – 22.4Germany 37.6 33.9 37.1South Korea – 17.0 18.2Czech Republic – 30.6 34.9India 88.5 87.3 84.6

the area of energy efficiency improvement from being copiedelsewhere without compensation.58

6.2.2.6.3 Green Power

Green power policies establish mechanisms through which partof the electricity supply (whether in a regulated or competitiveenvironment) must come from designated renewable energysources. Regulatory policy mandates include set-asides forrenewables, renewable portfolio standards (RPSs), and variouskinds of subsidies created from SBCs or renewable energyfunds. The cost of compliance for policy mandates is borne byall consumers. Despite this 100% participation, however, thepolicies may or may not be effective in stimulating renewableenergy generation, depending on how aggressive they are andhow they are implemented. Some examples are given in Boxes6.6 and 6.8. To reduce the cost of compliance regulatory poli-cy may be supplemented by tradable renewable energy certifi-cates as described in Box 6.7.

Green power and green pricing programmes encourage con-sumers to voluntarily pay a higher price for electricity generat-ed from “green” (environmentally friendly) energy sources.Green power products are offered by some suppliers whereelectricity markets have been liberalized, while green pricing isa green power option offered by the monopoly utility in juris-dictions where consumers are not yet permitted to choose theirretail provider (Swezey and Bird, 2000). Green power market-ing programmes are relatively new, dating from 1993, and arebeing implemented in Australia, Canada, Germany,Netherlands, Switzerland, UK, and USA (Markard, 1998;Crawford-Smith, 1999; Holt, 2000a, 2000b).

In the USA, about 30 green power products are being market-ed by 15 retailers in competitive states and about 140 electricutilities offer a green pricing option that emphasizes wind orphotovoltaics (Holt and Wiser, 1998; Holt, 2000b). Marketpenetration so far is low, a little over 1% on average, althoughit reaches as high as 4%–5% for a few utility programmes(Wortmann et al., 1996; Holt, 2000a, 2000b). Of those whoswitch suppliers in competitive markets, some 20%–95%choose a green power product (the higher percentage resultsfrom significant renewable energy subsidies in California).

Wiser et al. (2000) assessed green power marketing pro-grammes in the USA. They conclude that the collective impactof customer-driven demand for renewable energy has beenmodest to date, but that it is too early to draw definitive con-clusions about the potential contribution of green power mar-keting in the long run.

In support of green power marketing and of policies that man-date renewable set-asides and RPSs, renewable energy certifi-cates (also called credits, labels, or tags) may be traded sepa-

rately from green electricity. Whether renewable energy orother environmental attributes should remain with the purchas-er of the underlying commodity, or be sold to different entities,is under debate. There are either plans for or limited experiencewith tradable certificates in Belgium, Denmark, Italy,Netherlands, UK, and USA, and it is likely to grow in impor-tance (Benner, 2000; Rucker, 2000). Trading in renewableenergy certificates promises greater liquidity and potentiallylower costs to meet policy commitments and marketing claims.An example is given in Box 6.7.

6.2.2.6.4 Demand-side Management

Information programmes are often applied in combination withother initiatives (such as rebating in DSM programmes, energyaudits, labelling, and regulation). In the US cumulative electricutility DSM spending to date is about US$15–20 billion. Closeto 60% of utility customers are served by such programmes.Reductions in national electricity demand of 3%–4% percentwere achieved with these programmes (Hadley and Hirst,1995; Eto et al., 1996). Studies on the efficiency of DSM pro-grammes find that a large proportion of the reported conserva-tion impacts are statistically observable after accounting foreconomic and weather effects (Parfomak and Lave, 1997).

With utility restructuring and the emergence of electricity gen-eration competition, the rationale of utility resource acquisitionhas been greatly diminished. The new generation of pro-grammes funded by SBCs emphasizes permanent market trans-formation effects aimed at technology manufacturers, includ-ing financial incentives paid directly to manufacturers, guaran-teed minimum market sales for new energy efficient products,and competitive technology procurement programmes.

6.2.3 Mixes of National Policy Instruments

Section 6.2.2 discusses various policy instruments to manageGHG emissions in isolation. Various authors (e.g., Bernstein,1993; Richards, 1998; Stavins, 1998b) argue that to select thebest approach to attain the environmental goal, various costand other aspects must be taken into account. These includeproduction costs, cost differences across sources, transactioncosts, monitoring and enforcement costs, implementation,administrative costs, and other socio-economic conditionsidiosyncratic to each country. For these reasons, it can be antic-ipated that in most countries GHG emissions will be managedusing a portfolio of policy instruments, rather than a single pol-icy instrument. Furthermore, the portfolio of instruments islikely to differ from country to country. Using a portfolio ofpolicy instruments enables a government to combine thestrengths, while compensating for the weaknesses, of individ-ual policy instruments, thus improving overall effectivenessand efficiency.

Under some conditions a combination of market-based andinformation policies and regulations can improve economic


58 For some additional remarks see also Section 6.5.3.

efficiency. Well-designed policies aimed at energy prices areeconomically most efficient when transaction costs are lowand/or cannot be substantially reduced through market transfor-mation policies. They also work best when the potential fortechnological learning by doing is small or known with reason-able certainty. Well-designed regulatory and incentives-basedpolicies aimed at factors other than energy prices are economi-cally most efficient when the transaction costs are large and canbe substantially reduced at low administrative cost. They alsowork best when the potential for technological learning by doingis large. Virtually all end-use markets for energy efficiency suf-fer from high transaction costs and related market problems.Also, many energy efficiency and renewables technologies

exhibit large potentials for learning by doing. The most effectiveand economically efficient approach to achieve lower energysector emissions is to apply market-based instruments, stan-dards, and information policies in combination. Policies toadminister energy price changes provide a uniform signal to alleconomic actors and overcome fragmentation. Standards andinformation policies can move the economy closer to the fron-tier of production possibilities, which raises total factor produc-tivity.

Overriding non-economic reasons may also exist for combiningdifferent types of policy instruments to manage GHG mitiga-tion. First, the number and diversity of sources is large and even


Box 6.6. Examples of Policies to Promote Renewables in a Liberalized Power Market

Renewables Set-asideThe UK has been promoting wind and other renewable energy technologies through its Non Fossil Fuel Obligation (NFFO; see Mitchell,1995a, 1997). The renewable NFFO sets aside a certain portion of the electricity market to be supplied by designated renewable energytechnologies under a competitive bidding framework. Within each technology band (wind, biomass, landfills, solar, etc.) developers sub-mit bids of proposed projects and the projects with the lowest cost/kWh price are awarded power purchase contracts. Regional electric-ity companies are mandated to purchase power from NFFO-awarded renewable electricity generators at a premium price. The compa-nies are reimbursed for the difference between the NFFO premium price and the average monthly power pool purchasing price throughthe Fossil Fuel Levy (Mitchell, 1995a). The main weakness of the NFFO is that the implementation rate of approved projects is very low,because bids have such low cost/kWh that they do not allow the profitable operation of projects. Moreover, the intermittent character ofNFFO rounds has precluded the development of a steady domestic market for renewable technologies (Michaelowa, 2000).

Renewable Portfolio Standard (RPS)The RPS has received considerable attention in the USA. The RPS is similar to the NFFO concept in the UK, in that both are competi-tive least-cost mechanisms. Unlike NFFO there is no funding levy. Under RPS, all retail power suppliers are required to obtain a certainminimum percentage (e.g. 5%) of their electricity from specified renewable energy sources. Efficiency is obtained by allowing the mar-ket to determine the most cost-effective solution for each electricity retailer (Radar, 1996; Haddad and Jefferis, 1999). State legislaturesand/or public utility commissions have approved various versions of RPS in several US states (Wiser, 1999b).

Production Subsidy and/or System-benefit Charges (SBCs)Another support mechanism to promote renewables in a liberalized electricity market is a fee/kWh on all energy users to support renew-able energy development. This charge is often referred to as SBCs (Haddad and Jefferis, 1999). In California, a total of US$540 millioncollected from 1998 up to 2002 from electricity customers is directed to support existing, new, and emerging renewable electricity gener-ation technologies (California Assembly Bill, 1996, AB 1890, Ch. 854, Sec. 381). In addition, nine other states in the USA have estab-lished SBC policies under the restructuring of their electric utility industries to promote the use of renewables (Wiser, 1999b). Unlike inNFFO and RPS, there is no supplier obligation.

Box 6.7. Green Certificates for Wind Energy in the Netherlands

Support for wind energy in the Netherlands has included both R&D grants and a variety of market-stimulation mechanisms. Thesehave included an integrated programme for wind energy, which provided subsidies of 35–40% of investment costs for newly built tur-bines. Electricity distribution companies raised environmental levies to purchase wind generated kiloWatt hours for high guaranteedprices (about US$0.07; Wolsink, 1996). More recently, however, significant changes have occurred in the Dutch renewable energy pol-icy, reinforced by the liberalization of the electricity market. Most of the direct subsidies are now eliminated and other market-orient-ed and fiscal mechanisms introduced. One such mechanism is the green certificates market, which started in 1998. By law, local ener-gy distribution companies must purchase renewable electricity from independent power generators. Distribution companies issuegreen certificates to the renewable generators equal to the amount of renewable kiloWatt hours sold to the grid. The renewable gen-erator can then sell these green certificates on an open market to distribution companies that want to sell green-certified electricity(Schaeffer et al., 1999). Green electricity is exempt from energy taxes, which will be raised to about US$0.06/kWh in 2001. The taxexemption makes wind energy competitive with electricity from conventional sources, and thus the subsidies are obsolete.

the most comprehensive instruments (an emissions tax or a trad-able permit system) is not suitable for all of these sources.Second, the conditions needed to administer efficiently thesecomprehensive instruments (e.g., a manageable number of par-ticipants, but enough to create a competitive market for a trad-able permit system) may reduce the scope of their application.Third, different policy instruments can be used to distribute themitigation-cost burden across sources in ways that lessen oppo-sition to the policy goal. Fourth, policy instruments have multi-ple impacts, so different instruments and sets of impacts are pre-ferred for different sources. Finally, governments have frequent-ly adopted a portfolio of policies, rather than a single policyinstrument, to deal with complex environmental issues.

One important aspect in the policy analysis has been a shift ofattention from the assessment of single policy instruments toquestions of the optimal policy mix (OECD, 1996b). Assessingthe performance of particular environmental policy instru-ments from historical evidence is difficult because these wereoften combined in policy packages, as was the case with the

phase-down of leaded petrol in a number of European coun-tries. Econometric analysis has been employed to separate outthe effects of individual policy instruments under such condi-tions, but this is not always possible (Katsoulacos andXepapadeas, 1996; Boom, 1998).

6.3 International Policies, Measures, and Instruments

Although only Annex I Parties that have made commitmentsunder the Kyoto Protocol’s Annex B have quantified emissionslimitations, all Parties have committed to take climate changeconsiderations into account, to the extent feasible, in their rel-evant social, economic, and environmental policies and actions(UNFCCC, 1992, Article 4.1.f). It is recognized, however, thatnon-Annex I Parties’ efforts to take actions that contribute tonational development and GHG emissions reduction may belimited by capital constraints, lack of knowledge, or other fac-tors. The UNFCCC and the Kyoto Protocol, therefore, includeseveral provisions that can help overcome such barriers, such


Box 6.8. Renewable Energy Policy in India

Renewable energy (RE) sources were first recognized and incorporated in official policy documents in the early 1970s. Several nation-al-level programmes for RE technologies have been initiated, for example, the National Project for Biogas Development (NPBD) witha target of 1.5 million plants by 2001, a national programme for improved cook-stoves, a programme for mass demonstration of REsources like wind, solar, biomass, etc. The Ministry of Non-conventional Energy Sources (MNES) co-ordinates and implements theRE policy at the national level with counter-part departments in the state governments. The Indian Renewable Energy DevelopmentAgency (IREDA) operates a revolving fund for development, promotion, and commercialization of RE through the provision of softterm financial assistance.

Under the New Strategy and Action Plan for RE, the following, two-pronged action plan was devised:• High priority accorded to generation of grid-quality power from wind energy, small hydropower, bio-energy and solar energy.• Rural energization programme is promoted through:

− electrification of villages through photovoltaic and biomass gasifier power systems,− supply of solar lanterns to unelectrified households,− use of solar water heating systems, − rural energy programmes, for example, National Project on Biogas Development,− production of energy from agricultural waste, etc.

Currently, a three-fold strategy has been pursued by the government for promotion of RE sources through private sector involvement.These include:• Providing budgetary resources by government for demonstration projects.• Extending institutional finance from IREDA and other financial institutions for commercially viable projects, with private sector

participation; and external assistance from international and bilateral agencies. • Promoting private investment through fiscal incentives, tax holidays, depreciation allowance, facilities for wheeling and banking

of power for the grid and remunerative returns for power provided to the grid. The emphasis has shifted from direct financial incen-tives (e.g., subsidies) to indirect fiscal incentives (e.g., low interest loans, financing packages for consumers, reduced tariff andtaxes, viable power-purchase prices, etc.). Some fiscal incentives include: accelerated 100% depreciation on specified renewableenergy based devices/projects, 100% tax deduction from profits and gains for first five years of operation, and 30% for the nextfive years for industrial undertakings set up for generation and/or distribution of power.

The new policy for RE tried to give a focus on commercialization and, market orientation and to encourage greater private sectorinvolvement. Despite this there exists significant unexploited potential. The main barriers are: high initial and transaction costs, under-developed markets and market-support infrastructure for RE products, weak linkages between market development and R&D, prod-uct development not responsive to users’ needs, and the pricing of conventional energy sources (TERI, 2000).

as the provision that:• All Parties are “committed to promote and co-operate

in the development, application and diffusion, includ-ing transfer, of technologies, practices and processesthat control, reduce or prevent anthropogenic emissionsof greenhouse gases not controlled by the MontrealProtocol in all relevant sectors, including the energy,transport, industry, agriculture, forestry and waste man-agement sectors” (UNFCCC, 1992, Article 4.1.c).

• Parties agreed to establish a financial mechanism “forthe provision of financial resources on a grant or con-cessional basis, including for the transfer of technolo-gy” (UNFCCC, 1992, Article 11.1).

Additionally,• “The CDM created by the Kyoto Protocol creates an

incentive for (entities in and governments of) Annex IParties to assist the development and implementation ofclimate change mitigation projects that contribute tosustainable development in, and are approved by, anon-Annex I Party” (UNFCCC, 1997, Article 12).

This section discusses the three Kyoto mechanisms: interna-tional emissions trading (IET) (Article 17) in Section 6.3.1(for some clarifying remarks, see also Section 6.1.3), and JI(Article 6) and the CDM (Article 12) in Section 6.3.2.Thereafter, the section deals with international transfers(Section 6.3.3) and with the various other international poli-cies, measures, and instruments (Section 6.3.4).

6.3.1 International Emissions Trading

If the Kyoto Protocol comes into force Annex I Parties willhave agreed to an allocation of AAs (here also called emissionquotas) of GHG emissions for the first commitment period,2008 to 2012. Article 17 of the Protocol allows them to tradepart of these emission quotas among themselves in accordancewith rules currently being negotiated.59

IET implies that countries with high marginal abatement costs(MACs) may acquire emission reductions from countries withlow MACs. In principle, such trading tends to equalize MACsacross these countries, so that an aggregate emissions reduc-tion can be attained cost-effectively.60 Parties have not yetdecided whether IET based on Article 17 will be restricted togovernments or whether legal entities also will be allowed toparticipate with the approval of their national governments. To

support compliance with their AAs after adjusting for trading,governments may use any of the domestic policy instrumentsdiscussed in Section 6.2 above.

Limiting all transactions to multilateral and potentially anony-mous trade on an exchange would help IET move in the direc-tion of becoming efficient and non-discriminatory. Bilateraltrading cannot be relied upon to reveal to others the true fulltransaction prices (including undisclosed side-payments),which is required to give all participants equal access to gainsfrom trade. Non-anonymous trading may eliminate transac-tions between Parties who are in conflict with each other, thusreducing market efficiency. Transparent, anonymous, and effi-cient trading would be possible on a continuous stock-exchange kind of market (Bohm, 1998). The scope for theexertion of market power is small on such markets, contribut-ing to efficiency (Smith and Williams, 1982).

According to Article 17 in the Protocol, “any such trading shallbe supplemental to domestic actions for the purpose of meet-ing quantified emission limitation and reduction commit-ments.” How to implement this provision is still underdebate.61 A restriction on free IET as a result of binding sup-plementarity requirements could prohibit equalization of theMACs across participating countries, and hence increaseaggregate abatement costs.62

It has also been argued that constraints on the use of IET andthe project-based Kyoto mechanisms (see also Section 6.3.2)might accelerate technological innovation in Annex I countriesby increasing the relative price of alternative options for car-bon mitigation. Limited analytical studies are inconclusive asto whether such constraints will induce significant innovation,but do suggest that they could reduce the flow of technology toother countries.

An initial quota allocation that turns out to exceed a baselineprojection for a country’s emissions–possibly relevant forsome signatories of the Kyoto Protocol with substantialchanges in political and economic systems since 1990–impliesthat sales of AA units (AAUs) will exceed emission reductionsbecause of active climate mitigation policies, sometimesreferred to as “hot air”. Restricting trade of “hot air”, as someParties have proposed, would force larger reductions in emis-


61 Each of the mechanisms, not just IET, includes a so-called supple-mentarity provision, although the wording differs in the case of theCDM. Some Parties have proposed rules to address supplementaritythat apply an overall limit on the use of the three mechanisms, ratherthan a separate limit for each mechanism.

62 For a preliminary estimate of the cost implications of the EU pro-posal for the definition of supplementarity, see Baron et al. (1999),Bernstein et al. (1999), Criqui et al. (1999), and Ellerman and Wing(2000). See Woerdman (2000) and Michaelowa and Dutschke (1999a)on additional reasons for supplementarity.

59 With sufficient incentives, some non-Annex I Parties may ask tojoin in IET, replacing their expected use of the CDM, which is dis-cussed in Section 6.3.2.2 (Barros and Conte Grand, 1999; Bohm andCarlén, 2000; Montero et al., 2000).

60 For illustrations of the potential gains from IET, see Bohm (1997),Manne and Richels (1999), and Weyant and Hill (1999).

sions by countries that would otherwise import emissions quo-tas during the first commitment period.63 In addition, con-straints on hot-air trading, other things being equal, wouldmake the Protocol less beneficial for some countries with “hotair” allocations (Bohm, 1999).

Emissions trading creates a risk that sellers of AAUs might notundertake the emissions reductions that their sales require, inspite of the political costs of non-compliance and despite thesanctions to be instituted. Several options that provide Annex IParties with an incentive to transfer only part of their AAUsthat are surplus to their compliance needs are under considera-tion. Such options, called liability provisions, are discussed inSection 6.3.5.3. Liability provisions are intended to enhanceenvironmental integrity and are also necessary for the func-tioning of the market.

6.3.2 Project-based Mechanisms (Joint Implementationand the Clean Development Mechanism)

Project-based mechanisms allow actions that reduce GHGemissions from, or enhance sinks beyond, what would other-wise occur to receive “credits” for the emissions mitigated;these credits can be used by Annex I Parties to help meet theiremissions limitation commitments. These mechanisms includetechnology transfer and provide opportunities for mutual co-operation. JI involves emissions reduction or sink enhancementprojects in Annex I countries. CDM involves emissions mitiga-tion projects in non-Annex I countries.64 Central to these mech-anisms is the operational definition of what emissions wouldhave been in the absence of the project; the baseline from whichemission reductions (or sink enhancements) are measured. Thissection focuses on setting the baselines for crediting.

6.3.2.1 Joint Implementation (Article 6)

Article 6 of the Kyoto Protocol allows an Annex I country tocontribute to the implementation of a project to reduce emis-sions (or enhance a sink) in another Annex I country and toreceive emission reduction units (ERUs) equal to part or all ofthe emission reduction (sink enhancement) achieved. TheERUs received by the investor country can be used to helpmeet its national emissions limitation commitment.

In the case of JI, some analysts have suggested that an inde-pendent authority responsible for approving the project base-

line is needed in addition to the Parties’ approval of the project.Others argue that the host government has an incentive toensure that ERUs are issued for real emission reductions onlyif the government is bound to strong and credible penalties fornon-compliance (see also Section 6.3.5).

Numerous issues related to JI remain to be agreed, including:• host and project eligibility;• the possibility of awarding ERUs for emission reduc-

tions from JI projects prior to the start of the first com-mitment period (see Parkinson et al., 1999);

• monitoring, verification, and reporting requirements;• baseline updating frequency;• ERU approval, registry, and trading conditions;• supplementarity provisions; and• incentives for compliance.

6.3.2.2 The Clean Development Mechanism (Article 12)

The purposes of the CDM are to assist non-Annex I Parties toachieve sustainable development and to contribute to the ulti-mate objective of the Convention while assisting complianceby Annex I Parties (UNFCCC, 1997, Article 12.2). The CDMallows a project to reduce emissions, or possibly to enhancesinks, in a country without a national commitment to generatecertified emission reductions (CERs) equal to the reductionachieved.65 Annex I Parties can use CERs to meet nationalemissions limitation commitments. In contrast to JI, for whichthere is little peer-reviewed literature, the literature is rapidlygrowing on the CDM (Goldemberg, 1998; Michaelowa andDutschke, 1998; TERI, 1998; Hassing and Mendis, 1999;Jepma and van der Gaast, 1999; Haites and Yamin, 2000).

A process for independent review of the certification of theemission reductions achieved is necessary for the credibility ofthe CDM. Article 12.4 establishes an executive board for theCDM and Article 12.5 specifies that emission reductions mustrepresent real, measurable, and long-term benefits related tothe mitigation of climate change and be certified by designat-ed operational entities. The certification process and therespective roles of the operational entities and the executiveboard remain to be defined, but they will be critical.

The host government must approve proposed CDM projects.As part of its approval process it will need to assess whetherthe proposed project contributes to sustainable development(Matsuo, 1998; Begg, et al., 2000). Some Parties have pro-posed criteria or procedures that the host government berequired to follow when determining whether a project con-tributes to sustainable development of the country (see alsoThorne and La Rovere, 1999; Chadwick, et al., 2000; Begg, etal., 2000).


63 The EU proposal to address supplementarity, for example, includesa provision that limits the transfers of quotas and thereby limits thetrade of “hot air”. Restricting trade of “hot air” allows these AAs to bebanked for use or sale during future commitment periods, thus reduc-ing the cost of compliance from what it otherwise would be during thefuture periods.

64 Whether sink-enhancement projects are eligible under the CDM isstill being negotiated.

65 How CDM projects can be financed is still being negotiated. SeeHaites and Yamin (2000) for a summary of options.

Investments in CDM projects by Annex I governments couldlead to a reduction in their official development assistance(ODA).66 The effect of government investment in CDM pro-jects on the level of ODA will be difficult to determine sincethe level of ODA in the absence of CDM projects is unobserv-able. However, historical figures compiled by the OECDDevelopment Assistance Committee could be used to try todeal with this.

Article 12.8 specifies that a share of the proceeds from CDMprojects will be used to cover administrative expenses and toassist developing country Parties that are particularly vulnera-ble to the adverse effects of climate change to meet the costs ofadaptation. Articles 6 and 17 do not impose a comparable levyon JI projects or international transfers of AAUs, although anumber of developing countries have proposed that the levy beapplied to all three mechanisms.

CDM projects can begin to create CERs upon ratification ofthe Kyoto Protocol. The advantage is that it supports develop-ing countries obtaining access to cleaner technologies earlier. Itmeans that a supply of CERs should be available prior to thestart of the 2008 to 2012 commitment period when they can beused by Annex I Parties.67 Parkinson et al. (1999) argue thatcreation of CERs during 2000 to 2007, which are creditedtowards 2008 to 2012 compliance, increases the emissions tra-jectories of Annex I countries for 2000 to 2012. They estimatethat increased Annex I emissions offset 30–60% of the CERscreated during 2000 to 2012.

Some analysts argue that the CDM facilitates the transfer ofCERs from low-cost emission reduction actions to Annex Iinvestors when they might subsequently be needed by the hostgovernment to meet a future emissions limitation commitment.However, this assumes a fixed stock of emission reductionactions. In practice, the stock of possible emission reduction(or possibly sink enhancement) actions changes over time inresponse to turnover of the capital stock, technological change,and other developments. Rose et al. (1999) analyzes the opti-mal strategy for a host government given a dynamic stock ofpotential projects.68

Numerous issues related to implementation of the CDMremain to be negotiated, including:

• host and project eligibility;• eligibility of sequestration actions;• demonstrating contribution to sustainable develop-

ment;• project financing arrangements;• monitoring, verification, and reporting requirements;• baseline establishment;• CER certification, registry, and trading conditions;• the share of proceeds for administrative expenses and

adaptation assistance;• adaptation assistance fund administration;• supplementarity provisions;• executive board composition and responsibilities;• process for designation of operational entities; and• penalties for non-compliance.

6.3.2.3 Baselines

Credible project-based mechanisms under the Kyoto Protocolrequire the achieved net emission reduction (sink enhance-ment) to be determined.69 The reduction is defined as the dif-ference between what emissions (sequestration) would havebeen in the absence of the measure, the baseline, and actualemissions (sequestration). Thus, the baseline is an estimate ofa situation that will never exist (Bohm, 1994; Jepma et al.,1998; Kerr, 1998; Begg et al., 1999).

Since the true baseline can never be observed, a baseline fromwhich emission reductions are calculated may be estimatedthrough reference to emissions from similar activities and tech-nologies in the same country or other countries, or to actualemissions prior to project implementation.70 Although thisjudgement is exercised through review by qualified, indepen-dent experts, possibly by stakeholders (such as environmentalorganizations), and by an entity with the final decision author-ity, the baseline will be an approximation of the counterfactu-al.71 One way to reduce baseline uncertainty may be to limitthe crediting period or to issue credits for only a fraction of theestimated emission reductions. However, this reduces theinvestors’ interest in financing the projects.

Baseline determination requires a trade-off between the trans-action costs of certification and the environmental costs ofadverse selection, adjustments for increased emissions at other


66 Therefore, some developing countries have proposed that a finan-cial additionality requirement, which currently exists for the AIJ pilotphase and states that ODA funds should not be invested in such pro-jects, should be extended to include the CDM. This view is not nec-essarily shared by all Parties.

67 Estimates of the potential of the CDM are mounting (see, e.g.,Austin et al., 1998; Ellerman and Decaux, 1998; Zhang, 1999a), butthe estimates are very sensitive to the rules applied for the CDM andthe other Kyoto mechanisms.

68 Contractual options to address this concern are available as well; thehost government can insist on an option to acquire the right to futureCERs from a project without cost at a specified future date, such as2013.

69 Note that the eligibility of sink enhancement projects under theCDM is still being negotiated.

70 Harrison and Schatzki (2000) examine how baselines are estab-lished for several environmental and energy programmes in the USA.

71 Parkinson et al. (2000) have estimated the range of uncertainty inestimates of emissions reduction because of the counterfactual natureof the baseline (based on a number of AIJ energy sector projects) tobe between ±35% and ±60% depending on the project type.

locations caused by the project (leakage), moral hazard, andchanges over time in contextual economic, technological, andinstitutional conditions. Several options for baseline method-ologies to try to deal with these trade-offs–including sectoralbenchmarks, dynamic baselines, and selective eligibility ofproject types–are discussed in the literature (Chomitz, 1998;Hargrave et al., 1998; Jepma, 1999; Michaelowa andDutschke, 1999a; NEDO, 2000). In addition, numerousIEA/OECD and other studies have been published on stan-dardization of baselines for specific sectors.72

Also several options for baseline determination have been pro-posed in the literature (Chomitz, 1998; Hargrave et al., 1998;Jepma, 1999; Michaelowa and Dutschke, 1999a; NEDO,2000). Several of these proposals try to deal with the issues ofadjustment for increased emissions at other locations (leakage)and changes to the baseline over time.

Regardless of the method used to develop the project baseline,the partners involved in the project, excluding the JI host gov-ernment, have an incentive to propose a baseline that yields aslarge a reduction as possible (Bohm, 1994; Wirl et al., 1998).73

Baseline inflation would increase the number of credits creat-ed and raise the return to investors and/or the host firm or coun-try. To minimize the risk of baseline inflation, an independentbody with the authority to review certifications could be iden-tified or created. In the case of the CDM the entity with theauthority to make the final decision will be the OperatingEntity, in accordance with the executive guidelines, or theExecutive Board, or the CoP/MoP (Meeting of the Parties). Inthe case of JI the entity will be the host government.74 Theprocess adopted by the independent body would also determinethe transaction costs involved in defining baselines.

6.3.2.4 Experience with Activities Implemented Jointly

Decision 1/CP5 of CoP1 in 1995 established a pilot phase foremissions reduction projects called Activities ImplementedJointly (AIJ). AIJ projects cannot create credits that can beused by Parties to meet commitments under the Convention orthe Kyoto Protocol. This is a crucial difference between AIJand JI or CDM projects. Table 6.2 summarizes the characteris-tics of AIJ projects.

Dixon (1999) provides a comprehensive review of the experi-ence with AIJ projects and the implications for JI and CDMprojects, illustrating the valuable experiences gained in projectbaseline development and monitoring. However, severalauthors argue that AIJ projects may not be representative of


72 For example, recent OECD/IEA baseline study references are:“Revised Framework for Baseline Guidelines”, “Multi-ProjectEmission Baselines: Iron and Steel Case Study”, “Multi-ProjectEmission Baselines: Final Cement Case Study”, “Multi-ProjectEmission Baselines: Forestry Status Report”, “Multi-Project EmissionBaselines: Final Case Study on Energy Efficiency”, Multi-ProjectEmission Baselines: Final Electricity Case Study”, and “Case-Studieson Baselines for the Project-Based Mechanisms” (seehttp://www.oecd.org).

73 Parties may not respond to these incentives, for instance, if such aresponse is incompatible with good business practices or would gen-erate public criticism.

Table 6.2: Characteristics of activities implemented jointly projects

Number of projects 94 Annex I countries: 68; non-Annex I countries: 26

Investors Public sector: 61; private firms: 32

Project types Renewable energy: 44%; energy efficiency: 38%; forestry or agriculture: 15%

Project life (years) 16.5a Range: 1 year to 60 years

Average emission reduction (tCO2eq) 1,658,320 Range: 13 × 106 to 57,467,271 (tCO2eq)

Average investment US$6,298,065 Range: US$73,000 to US$130,000,000

Total investment US$558,000,000b

Average cost of emission reductions Annex I: US$97/tCO2eq; excluding “expensive” projects: US$26/tCO2eq

Other: US$158/tCO2eq; excluding “expensive” projects: US$9/tCO2eq

Source: Woerdman and van der Gaast, 1999.aAverage lifetime of projects considered.bTotal investment in all projects considered.

74 The host government for JI projects has an incentive to minimizebaseline inflation only if it faces effective penalties for non-compli-ance. Otherwise the benefits from the project could exceed the penal-ties because of non-compliance. If the penalties for non-complianceby Annex I Parties are weak or poorly enforced, JI projects could besubject to an international review process with authority to establishthe quantity of ERUs issued and/or the ERUs could be incorporatedinto the liability provisions (see Section 6.3.5.3).

future JI and CDM projects (JIQ, 1998; Trexler, 1998;Woerdman and van der Gaast, 1999). Others suggest that AIJprojects provide limited guidance on how to establish baselinesfor emissions reduction or sequestration projects (Ellis, 1999;Lile et al., 1999).

6.3.3 Direct International Transfers

The UNFCCC states that Annex II Parties (basically Annex IParties except for the Parties in Central and Eastern Europe) shallprovide new and additional financial resources, including thetransfer of technology, needed by the developing country Partiesto meet the agreed full incremental costs of implementing mea-sures taken under the Convention and that are agreed between adeveloping country Party and the international entity or entitiesreferred to in Article 11 of the Kyoto Protocol (UNFCCC, 1997,Article 11). So, the extent to which developing country Partieseffectively implement their commitments under the Conventionwill depend on the effective implementation by developed coun-try Parties of their commitments under the Convention related tofinancial resources and transfer of technology.

6.3.3.1 Financial Resources

Sustainable development requires increased investment, forwhich domestic and external financial resources are needed,particularly for developing countries (UN, 1992, Agenda 21,Chapter 34). In its Resolution 44/228 of 1989 giving a mandateto the convening of the UN Conference on Environment andDevelopment (UNCED) in Rio de Janeiro, the UN GeneralAssembly notes, inter alia: “that the largest part of currentemission of pollutants into the environment originates in devel-oped countries, and therefore recognizes that those countrieshave the main responsibility for combating such pollution”,and that “new and additional financial resources will have to bechannelled to developing countries in order to ensure their fullparticipation in global efforts for environmental protection.”Developed country Parties reaffirmed their commitments in therelated provisions of the Kyoto Protocol. “The implementationof these existing commitments shall take into account the needfor adequacy and predictability in the flow of funds and theimportance of appropriate burden sharing among developedcountry Parties” (UNFCCC, 1997, Article 11).

Accordingly, Agenda 21 (UN, 1992, Chapter 33, especially its15th Section) carries the consensus formulation that for devel-oping countries: “ODA is a main source of external funding,and substantial new and additional funding for sustainabledevelopment and implementation of Agenda 21 will berequired.” In practice, however, there has been a clear trend ofa continuing decline in ODA levels since UNCED. Total ODAdropped from 0.35% of total gross national product of thedeveloped countries in 1991 to 0.29% in 1995, with furtherdeclines in 1996 and 1997 (OECD, 1998c). Some developedcountries are contributing to solving the environmental prob-lems that developing countries face with financial resources

other than ODA. For instance, the Japanese government isimplementing the Green Aid Plan that aims to achieve botheconomic development and environmental protection in devel-oping countries in Asia. Most developing countries maintainthat a sufficient level of financial resources is key to effectiveimplementation of Agenda 21 and is a priority issue to beresolved to enable the implementation of the global consensusreached at the UNCED.

6.3.3.2 Technology Transfer

The transfer of environmentally sound technologies fromdeveloped to developing countries has come to be seen as amajor element of the global strategies to achieve sustainabledevelopment and climate change mitigation. Article 4.5 andother relevant provisions of the UNFCCC (UNFCCC, 1992)clearly define the nature and scope of the technology transfer,which includes environmentally sound and economicallyviable technologies and know-how conducive to mitigating andadapting to climate change. Technology transfer implementedthrough the financial mechanism of the UNFCCC is to be “ona grant or concessional basis”, on non-commercial terms. TheParties included in Annex II “shall take all practicable steps topromote, facilitate and finance, as appropriate, the transfer of,or access to, environmentally sound technologies and know-how to other Parties, particularly developing country Parties, toenable them to implement the provisions of the Convention.”Article 10, paragraph (c) of the Kyoto Protocol (UNFCCC,1997) reiterated that all Parties shall: “co-operate in the pro-motion of effective modalities for the development, applicationand diffusion of, and take all practicable steps to promote, facil-itate and finance, as appropriate, the transfer of, or access to,environmentally sound technologies, know-how, practices andprocesses pertinent to climate change, in particular to develop-ing countries, including the formulation of polices and pro-grammes for the effective transfer of environmentally soundtechnologies that are publicly owned or in the public domainand the creation of an enabling environment for the private sec-tor, to promote and enhance the transfer of, and access to, envi-ronmentally sound technologies.”

Three conditions have to be fulfilled for an effective transfer oftechnologies. First, the technology holder country must bewilling to transfer the technology. Second, the technology mustfit into the demand of the recipient country. Third, the transfermust be made at reasonable cost to the recipient. The IPCCSpecial Report on Technology Transfer (IPCC, 2000) identifiesvarious important barriers that could impede environmentaltechnology transfer, such as:

• lack of data, information, and knowledge, especially on“emerging” technologies;

• inadequate vision about and understanding of localneeds and demands; and

• high transaction costs.

Some analysts argue with respect to the third item that the tech-nology should be provided on favourable terms and therefore on


non-commercial conditions, strictly separated from traditionaltechnology transfers, and supported by government funding.

In fact, Agenda 21 (UN, 1992) states that “governments andinternational organizations should promote effective modalitiesfor the access and transfer of environmentally sustainable tech-nologies (ESTs) by means of activities, including the formula-tion of policies and programmes for the effective transfer ofESTs that are publicly owned or in the public domain.” Themajor role of the government could be to supply EST researchand develop funds to transfer publicly owned technology todeveloping countries. In this regard, the Commission onSustainable Development, at its fifth session, concluded that: “aproportion of technology is held or owned by Governments andpublic institutions or results from publicly-funded research anddevelopment activities. The Government’s control and influ-ence over the technological knowledge produced in publicly-funded research and development institutions opens up a poten-tial for the generation of publicly-owned technologies thatcould be made accessible to developing countries, and could bean important means for Governments to catalyze private sectortechnology transfer.” In all countries the role of publicly fund-ed R&D in the development of ESTs is significant. Throughboth policy and public funding, the public sector continues tobe an important driver in the development of ESTs.

An additional role of the government is to make the legal pro-visions for the transfer of ESTs (including checking on abuseof restrictive business practices (Raekwon, 1997)). Good gov-ernance creates an enabling environment for private sectortechnology transfer within and across national boundaries.Although many ESTs are in common use and could be diffusedthrough commercial channels, their spread is hampered byrisks such as those arising from weak legal protection and inad-equate regulation in developed and developing countries.However, many technologies that can mitigate emissions orcontribute to adaptation to climate change have not yet beencommercialized. Beyond an enabling environment, it will takeextra efforts to enhance the transfer of those ESTs (IPCC,2000). It should also be recognized that the effective transfer ofESTs requires substantial upgrading of the technologicalcapacities in the developing countries (TERI, 1997) (see alsoChapters 5 and 10).

6.3.4 Other Policies and Instruments

6.3.4.1 Regulatory Instruments

There are two ways to apply regulatory instruments interna-tionally. One is to establish uniform standards for various prod-ucts and processes for adoption by countries that participate inan international emission reduction agreement. There are sev-eral reasons why establishing uniform international standardsfor GHGs reduction is unlikely; for example, it is difficult toachieve agreement on the appropriate standards by affectedinterest groups in participating countries, and such an approach

would limit the domestic policy choices of individual coun-tries. The second way is to adopt fixed national emission lev-els (non-tradable emission quotas) for participating countries.These national emission limits can be considered performancestandards that each country must meet through domesticaction. This leads to inefficiency because marginal emissionabatement costs differ among countries (IPCC, 1996, p. 404).

6.3.4.2 International and Harmonized (Domestic) CarbonTaxes

An international carbon tax, payable to an international agency,or domestic carbon taxes harmonized across countries, offerpotentially cost-effective means of obtaining CO2 reductions(IPCC, 1996, 11.2.2.2).75 By associating a uniform price withcarbon emissions in every country, only reductions that costless than the tax will be implemented, assuming that the tax isimplemented perfectly. To provide a common price signal in allcountries, the new carbon tax may need to be differentiatedacross countries to account for existing domestic fuel taxes andrevenue constraints (Hoel, 1993). Providing a common pricesignal to all sources subject to the tax also requires that allcountries refrain from policies that directly or indirectly offsetthe tax (such as subsidies or regulations).

The revenue raised by an international carbon tax must beredistributed or used in an agreed manner. It is likely to be dif-ficult to obtain an agreement on the share of the revenue thateach country should receive. Harmonized domestic taxes avoidthis difficulty by letting each country keep the revenue it col-lects. In practice, it is difficult also to achieve agreement onminimum levels of harmonized carbon and/or energy taxeshigh enough to impact carbon emissions significantly. Politicalpressures to combine tax proposals with exemptions for spe-cific sectors contribute to this difficulty and, if accepted,reduce the efficiency and effectiveness of the tax.

International or harmonized taxes provide greater certaintyabout the likely costs of an emissions reduction programme,compared with a similarly designed international emissionstrading programme (Toman et al., 1999). This advantage canalso be obtained by a hybrid policy, consisting of domesticemissions trading programmes coupled with a harmonized“trigger price”, at which countries would sell additional per-mits domestically (McKibbin and Wilcoxen, 2000). The hybridpolicy sets an upper bound on the marginal cost of abatement(like a carbon tax), but otherwise operates like an emissionstrading programme. For a discussion of the pros and cons ofsuch a hybrid system, see Sections 6.2.2.2 and 6.2.2.3.

The two major concerns about international price-based poli-cies are the emissions levels, and the feasibility of internation-al agreement:


75 To improve efficiency a tax should be applied to as many sourcesof GHG emissions as feasible.

• The first concern is that price-based policies (taxes orhybrid systems) fail to guarantee particular emissionslevels if it is not possible to adjust the tax rate frequent-ly to achieve emission reductions in accordance with theset targets. If one assumes, for instance, that taxes arethe only instrument used to fulfil the Kyoto Protocolcommitments, in practice they most likely cannot guar-antee that emissions commitments will be fulfilledeither in the aggregate and/or for individual countries.

• The second concern is that an international agreementinvolving international or domestically harmonizedtaxes may be more difficult to negotiate than oneinvolving emissions quotas. Wiener (1998) argues thatthe voluntary assent nature of international agreementsmeans that nations must be made better off to partici-pate, unlike domestic policies for which individuals canbe coerced. While in theory international or domesti-cally harmonized taxes can be combined with side payments to compensate losers, in practice such sidepayments are difficult to negotiate and tend to intro-duce dynamic inefficiencies since individual firms (andcountries) do not bear the full social cost of their activities (Mestelman, 1982; Baumol and Oates, 1988;Kohn, 1992).76

Cooper (1998) takes the opposite position, arguing that taxesare the more feasible international approach. He argues thatbecause of their rising contribution to global emissions, the par-ticipation of developing countries is essential for the long-termsuccess of a programme to stabilize GHG concentrations in theatmosphere. He argues that it may be impossible to forge anagreement between rich and poor countries on the allocation offuture quotas. Instead, “mutually agreed-upon actions”, such asnationally collected emission taxes, are the logical alternative.

6.3.4.3 Standardization of Measurement Procedures

Several efforts are underway to standardize measurement pro-cedures. For example, in the automotive industry, manufactur-ers from Europe, Japan, and the USA, jointly with respectivegovernments, are trying to harmonize exhaust emission mea-surement methods for heavy-duty diesel vehicles (such as actu-al running conditions, measurement equipment, and proce-dures) by 2006. If successful, the automobile manufacturers’association intends to ask their respective governments to man-date the outcome.

Other international standards are set by the Organization forInternational Standardization (ISO). The ISO has begun to

establish international Environmental Management standardsin its 14000 series. The first standard among them (ISO 14001,Environmental Management Standard or EMS) was publishedin 1996 (ISO, 1996).

ISO environmental standards are framework standards and donot set any performance standards. They are flexible to facili-tate application by a wide variety of organizations throughoutthe world. An organization can select any environmentalaspects (such as emissions to air and/or water, ozone depletion,climate change, etc.) it considers important for its activities.This means that the standards may be effective as tools to copewith global warming if they are utilized for that purpose. InDecember 1997, the Climate Technology Initiative (CTI) of theOECD and the ISO issued a Joint Statement concerning thepotential contribution of international standards to climatechange (ISO, 1998a). In 1998, ISO established a ClimateTechnology Task Force to review the application of the ISO14000 series to climate change (ISO, 1998b).

In January 2000, ISO’s Technical Management Board estab-lished an Ad Hoc Group on Climate Change (AHGCC) todevelop a comprehensive ISO strategy for climate change.While ISO has not ratified a climate change strategy, theAHGCC has identified several areas in which the developmentand use of ISO standards may help facilitate implementation ofthe UNFCCC and its Kyoto Protocol, including (among oth-ers):

• codes of practice and guidelines for accreditation bod-ies and operational entities;

• CDM project validation, verification, and/or certifica-tion standards; and

• GHG measurement, monitoring, and reporting stan-dards.

6.3.4.4 International Voluntary Agreements with Industry

Several voluntary initiatives that have an international impacthave been identified. For instance, various multinational firmshave undertaken voluntary actions to cope with climatechange, including setting up emissions trading systems andengaging in trades.

A VA was concluded in July 1998 between the EC and theEuropean Automobile Manufactures Association (ACEA). TheEC subsequently negotiated a similar agreement with Japaneseand Korean car manufacturers. The agreements are expected toreduce CO2 emissions from new cars in 2008 by 25% belowthe 1995 level. Implementation is contingent on several pre-conditions, such as fuel quality improvement. The EC has beenengaged in discussions with European industry associationsregarding a possible VA on energy efficiency in televisions andvideocassette recorders (EEA, 1997).

The United Nations Environment Program (UNEP) Statementby Financial Institutions on the Environment and SustainableDevelopment and the UNEP Insurance Initiative may be clas-


76 Unlike side payments on a lump-sum basis, which remain efficient,side payments and/or subsidies determined by emission levels are not(because then the environmental impact of the original policy measurewould be reduced). In the case of a tradable quota regime, the sidepayments take the form of more generous quota allocations, which areefficient, unless they are tied to emission levels.

sified as international VAs. Banks and insurance companiesthat sign these initiatives have to pay attention to environmen-tal protection in their management and in their product selec-tions and operations. These initiatives are not binding and nomonitoring of conduct has been carried out. In addition, the ter-ritorial distribution of the signing banks and insurance compa-nies is uneven; participation from developing countries and theUSA is rare, and no Japanese banks signed the FinancialInstitutions Initiative.

Some domestic VAs may evolve as de facto international VAs.The Energy Star programme began in 1992 as a voluntary part-nership between the US DOE, the US EnvironmentalProtection Agency, product manufacturers, and others. Partnerspromote energy efficient products by labelling them with theEnergy Star logo and educating consumers about the benefitsof energy efficiency.77 A similar programme has started inJapan, and several European governments and manufacturersare considering setting up similar programmes. No analyses ofthe costs and impacts of these programmes are available.

6.3.5 International Climate Change Agreements: Participation, Compliance, and Liability

6.3.5.1 Participation

One of the concerns in the economics literature on environ-mental agreements (including the UNFCCC and KyotoProtocol) has been with increasing participation. The mostobvious way in which international agreements seek to increaseparticipation is by means of a minimum participation clause.This is an article that specifies the agreement will not be bind-ing on any of its Parties until a large enough number of coun-tries–and, sometimes, particular countries or types of coun-tries–have ratified the agreement. The minimum participationclause effectively makes the obligations of each of its signato-ries a (non-linear) function of the total number of signatories.

The minimum participation clause can serve as a strategicdevice, but this need not always be the case. Suppose that theminimum participation level is given as k+. Then, if the actualnumber of signatories is k, and k < k+ – 1, accession by a non-signatory neither costs this country anything nor confers uponit any advantage. This is because the agreement would not yetbe binding on this country. However, if k = k+ – 1, then acces-sion has a non-marginal effect on the environmental problem,for the accession will mean that all of the k+ countries mustundertake the measures prescribed by the treaty. One way tosustain full co-operation would be to set k+ equal to the totalnumber of countries affected by an environmental problem(i.e., all countries), while ensuring that every potentially par-ticipating country is better off with the agreement than withoutit. Obviously, the threat not to undertake any abatement for a

smaller value of k can be an important incentive for countriesthat consider joining the agreement to actually do so (becausethey believe that free-riding doesn’t pay). It is thereforeextremely important that this threat be credible. However, inthe vast majority of cases it will not be (Hoel, 1993; Carraroand Siniscalco, 1993; Barrett, 1994).

More importantly, the actual number of Parties to an agreementusually exceeds the minimum participation level, which isanother reason why the above threat mechanism cannot beused to deter free-riding. The minimum participation levelclause may rather serve as a co-ordinating device than as anactual incentive to join the agreement.

The point, however, is that while agreements must offer somealternative means for deterring free-riding, often they do not.The literature on international environmental agreementstherefore predicts that participation will be incomplete, and itoften is. One of the few agreements that disproves this generalrule is the 1987 Montreal Protocol on Substances that depletethe ozone layer (UNEP, 1987; revised and amended in 1990and 1992). The revised Protocol contains provisions that con-trol trade between Parties and non-Parties to the regime.Coupled with the financial resources available to developingcountries Parties that are not available to non-Parties, theParty–non-Party trade provisions are widely cited as a majorfactor in explaining the near universal participation in theozone regime (Rowlands, 1995). See also Chapter 10 for a fur-ther discussion on participation in international regimes.

6.3.5.2 Compliance

The bulk of environmental agreements cannot operate thefinancial “carrots” and/or trade restriction “sticks” illustratedby the ozone regime (Wiser, 1999a). The key question thereforebecomes: how can compliance by all Parties be secured, giventhe consensual basis of international law and the reluctance ofParties to endow international bodies with legal authority toenforce the international commitments Parties have (freely)undertaken against them? The UNFCCC has near universalparticipation based on the traditional consensual approach but-tressed by provisions that aim to facilitate developing countryparticipation through the provision of financial and technolog-ical resources. The general nature of the commitments con-tained in the Convention would, in any case, prove difficult toenforce. These factors explain why Parties have not endowedthe supreme body of the Convention, the CoP, with the author-ity to impose legally binding consequences on a Party in theevent of non-compliance. Thus at present, no legal body existsto enforce compliance in the climate change context.

The quantified, legally binding commitments of the KyotoProtocol pose a different challenge (Werksman, 1998). In theperiod after Kyoto, the majority of Parties signalled a cleardesire to move towards a compliance system based on legallybinding consequences, even though the compliance provisionsof the Kyoto Protocol provide that legally binding conse-


77 See http://www.epa.gov/appdstar/estar/

quences can only be adopted by means of a formal amendmentto the Protocol. Be that as it may, UNFCCC negotiations on theinstitutions and procedures of a compliance system for theProtocol are well advanced.

Various suggestions have been put forward in the literature andby Parties for the kind of legally binding consequences deemedappropriate in the climate regime (Corfee Morlot, 1998; Wiserand Goldberg, 2000). These include the following (Grubb etal., 1998; UNFCCC, 2000):

• allowing a “true-up” or grace period with opportunityto buy quotas;

• payment into a national or international compliancefund that would invest in quotas;

• issuing cautions and/or reports to motivate public pres-sure;

• suspending treaty privileges (such as voting or the rightto nominate members for office);

• exclusion from access to the Kyoto mechanisms; and• financial penalties and implementing trade sanctions.

As a result of the difficulties in agreeing any of these conse-quences, and their future enforceability, more attention has beenpaid to policy tools that prevent non-compliance. Again, sug-gestions in the literature and from the Parties focused on ensur-ing that emissions trading must be transparent at both the Partyand entity level78, and that emissions data, such as inventories,are publicly available. The idea being that Parties and/or firmsmay fear the reputation consequences of being identified as pol-luters. Furthermore, trading could be authorized only for eligi-ble Parties or entities, namely those meeting some minimumstandards on monitoring and reporting. Non-eligible Partiesand/or entities could be suspended from the trading system.

Parties also could require that insurance be obtained for tradedtonnes of emissions reductions. An extra quota reserve held forthe premium payer could then be claimed if the traded tonnesfail to be verified as emission reductions. A similar proposal isto establish a “true-up” period or grace period (of some sever-al months or years) after 2012; a party that is able to come intocompliance at the end of this true-up period would be deemedto have complied with the agreement. Several other possibili-ties have been mentioned to enforce compliance with theKyoto targets in a situation with IET.

6.3.5.3 Liability

Liability provisions prescribe how quotas transferred by aparty that subsequently is not in compliance with its emissionslimitation commitment are treated. Since the developing coun-try hosts of CDM projects do not have emissions limitationcommitments, this is not an issue for CERs once they havebeen certified and issued by the operational entity or the

Executive Board. However, this does not deal with the questionof what happens if the certification has not been undertaken toacceptable standards or if there are other significant irregulari-ties in issuance procedures. Since both JI and IET involve onlyParties with emissions limitation commitments, treatment ofquotas traded using these mechanisms must be addressed if theissuer does not achieve compliance.

With regard to JI, Article 6.4 of the Kyoto Protocol specifiesthat if compliance by an Annex I country is questioned underArticle 8, any ERUs acquired from that country cannot be usedto meet the buyer’s commitments under Article 3, until thequestion of non-compliance by the originating country is satis-factorily resolved (UNFCCC, 1997).

If the ERUs issued for JI projects are determined by an interna-tional review process, they reflect corresponding reductions ofthe host country’s emissions and hence do not contribute to itsnon-compliance. However, if the decision on the quantity ofERUs issued is left to the host government and the penalties fornon-compliance are weak or not effectively enforced, JI projectscould contribute to non-compliance by the host country. Sinceany ERUs transferred must be deducted from the party’s AA,they could be made subject to the liability provisions for IET.

Article 17 does not include any provisions to deal with quotasthat have been transferred by a country that subsequently failsto meet its emissions limitation commitment. A number ofoptions and variants have been proposed in the literature(Goldberg et al., 1998; Grubb et al., 1998; Haites, 1998;Baron, 1999; Zhang, 1999b). The proposals reflect variousstrategies, including seller and (its opposite) buyer liability, eli-gibility requirements for buyer and sellers, limits on the quan-tity of quota that can be sold, limiting sales to quantities sur-plus to estimated or actual compliance needs, or restoration ofdefault. These approaches can be grouped into those that aimto prevent or limit the risk of non-compliance, and thosedesigned to provide sufficient deterrence (either requiring thedefaulting party to face the regimes’ non-compliance system orelse harnessing the market to discount quotas from thoseParties considered to be most at risk).

These liability proposals differ in terms of their environmentaleffectiveness, impact on compliance costs of Annex I Parties,and market liquidity. The proposals can change the ratio ofdomestic reductions to purchased quotas used for complianceand the mix of quotas purchased. In this way they can changethe distribution of costs across countries, including non-AnnexI countries through the volume of CDM activity. In policyterms, it is likely that the most effective strategy would aim tocombine one or more of them. Details of how this may beundertaken, as well as on how many of the proposals would beimplemented in practice, are currently subject to internationalnegotiations.79


78 Given the wording of Article 17, the participation of legal entitiesin IET based on Article 17 would require an explicit decision byCoP/MoP (see also Section 6.3.1).

79 For example, whether under a buyer liability system transferredquotas would be invalidated pro rata or in reverse chronological order.

6.4 Interrelations Between International andNational Policies, Measures, and Instruments

6.4.1 Relationship Between Domestic Policies and KyotoMechanisms

It is important to consider ways in which international andnational (domestic) policy instruments are likely to comple-ment or conflict with one another in achieving GHG emissionsreduction commitments at least cost. A substantial number ofeconomic models suggest that use of the Kyoto mechanisms,established by Articles 6, 12, and 17 of the Kyoto Protocol (seeSections 6.3.1 and 6.3.2), combined with efficient domesticpolicies could significantly reduce the cost of meeting theemissions limitation commitments in the Protocol.80 Theresults of these models rely on assumptions of perfect foresightor certainty over future levels of emissions and on fully effi-cient domestic mitigation policies in Annex I Parties. They alsoassume that developing countries will respond to the marketsignal given by the international market of CERs and generateCDM projects accordingly.81 Moreover, these models implicit-ly assume that national economies are operating within an effi-cient market framework. However, when an inefficient marketframework is assumed the conclusions may differ. This is anarea in which further research is necessary.

Articles 6 and 12 of the Kyoto Protocol enable governmentsand entities of Annex I countries to support JI projects in otherAnnex I countries and CDM projects in non-Annex I countries,respectively, in return for emissions credits. Several countrieshave suggested the participation of legal entities in IET,although Article 17 (on IET) does not mention the participationof entities in IET other than Parties (see Australia et al. (1998)and United Kingdom of Great Britain and Northern Ireland(1998)).

The following discussion assumes that any supplementarityprovisions are not binding.82 In addition, MAC refers here tothe marginal social abatement costs. Also, in this discussion itis assumed that the initial market is perfect and then how vari-ous factors influence this is assessed.

If IET under Article 17 is limited to Annex I governments, theywould need to trade AAUs or introduce a domestic emissionstrading scheme to equate their national MACs. Views differ asto whether national governments have the information toequate the national MACs. Experimental evidence indicatesthat governments have the necessary incentive when tradingwith other governments.83 If both Annex I governments andlegal entities are allowed to engage in IET under Article 17,this difference of views becomes academic as long as thedomestic policies allow the legal entities to use the three Kyotomechanisms as part of their compliance strategy. Governmentparticipation in the Kyoto mechanisms changes the AAs avail-able for emissions by domestic sources.

For entities to equalize their MACs there must exist either afully comprehensive domestic taxation system, which reflectsthe international price of AAUs, or open access to the interna-tional emissions market for sources of emissions and entitiescovered by domestic policies. In theory, several domestic poli-cy regimes can be envisioned that would allow entities inAnnex I countries to equalize their MAC so as to minimize thetotal cost of reduction. The implications for different types ofdomestic policy instruments are as follows (Dutschke andMichaelowa, 1998; Hahn and Stavins, 1999):84

• Domestic tradable permits. The domestic tradable per-mit programme must cover virtually all emissionssources, the cap must be set equal to the national AAafter trading by the government, and the participantsmust be allowed to engage in international exchangesusing the Kyoto mechanisms.85 Participants would beallowed to use CERs and ERUs from CDM and JI pro-jects towards compliance with their domestic obliga-tions. The country could also host JI projects.Participants could also buy or sell AAUs under Article17 if participation by legal entities was allowed.86

• Domestic emissions and/or carbon tax. The domesticemissions and/or carbon tax must cover virtually allemissions sources, and the tax must be set equal to or


80 See Chapter 8 and Bernstein et al. (1999), Bollen et al. (1999),Cooper et al. (1999), Jacoby and Wing (1999), Kainuma et al. (1999),Kurosawa, et al. (1999), Manne and Richels (1999), McKibbin et al.(1999), Nordhaus and Boyer (1999), Tol (1999), Tulpulé et al. (1999),and Weyant and Hill (1999) for estimates of the cost savings resultingfrom various international quota trading arrangements. All the modelsassume efficient domestic policies, and international trading, withineach region. The models typically have between four and 20 regions.

81 See Baron and Lanza (2000) for a review of modelling results onthe contribution of the Kyoto mechanisms.

82 See Section 6.3.1 for a discussion of supplementarity.

83 An experiment with emissions trading among government teamsrepresenting four Nordic countries revealed a trading efficiency of97% (Bohm, 1997). Thus, their social MACs almost exactly equatedat the national level.

84 To explore the conditions under which different domestic policiescan minimize costs with the aid of the Kyoto mechanisms, Hahn andStavins (1999) examine pairs of countries with different combinationsof domestic policies. The discussion here presumes that all Annex IParties wish to implement domestic policies that enable all sources toequalize their MACs.

85 A similar system could be based on voluntary agreements in whichsources are allowed to trade emission reductions in the form of AAUs,ERUs, or CERs.

86 The permits used in the domestic tradable permit system could beAAUs. Alternatively, the domestic permits could be freely exchange-able for AAUs.

less than the national marginal cost of abatement aftertrading by the government. Entities receive tax creditsfor CERs and ERUs, and for AAUs if participation bylegal entities is allowed under Article 17. The countrycould also host JI projects.87

• Non-tradable permits. Virtually all sources are coveredby non-tradable emissions limits, which allow the useof quotas to achieve compliance. The total emissionsallowed under the permits must be equal to or less thannational AAs after trading by the government. Entitiescould use purchased CERs and ERUs–and AAUs ifparticipation by legal entities is allowed under Article17–towards compliance with their emissions limits.The country could also host JI projects to reduce emis-sions below the emissions limits or to enhance sinks.

If sources are subject to regulations, design or performancestandards, VAs, or taxes and at the same time there is no per-mit allocated to the source, and CERs, ERUs, or AAUs cannotbe used for compliance, entities might still be allowed to tradethem on the international market, provided that the volumesold does not exceed the volume of quotas acquired. Suchdomestic policies are unlikely to equate MACs across sourcesand so will not result in the lowest cost of compliance with thenational emissions limitation commitment.

In practice, the combination of domestic policies and Kyotomechanisms necessary to achieve cost-effectiveness may notbe implemented for at least two reasons. First, use of the Kyotomechanisms may be restricted in some countries, eitherbecause supplementarity restrictions are binding or because anational government that imposes an emissions tax may limitthe use of the mechanisms towards compliance with tax liabil-ities to protect its revenue.

Second, it is difficult to cover all sources and relevant sinkswith policies that provide an incentive to implement measuresthat equate MACs. Some sources are small and are excludedfor administrative reasons. Other sources, such as methaneemissions by livestock, are difficult to include in a trading ortax regime. Thus, the overall cost-effectiveness of the systemwill fall short of the theoretical ideal.

When part of the GHG emissions reduction needed to realizethe Kyoto commitments offers net economic benefits to thenational economy, the role of the Kyoto mechanisms changessignificantly. Relative to a theoretical scheme of complete andperfect trading, a purely national mitigation strategy would stillgive rise to inefficiencies for individual countries or sources, asa result of differentials in MACs. However, the advantages thatcould be obtained from eliminating such inefficiencies throughinternational mechanisms are more limited because of princi-pal-agent problems.

Thus, if access to the international mechanisms is limited togovernments, the Kyoto mechanisms are likely to be used onlyto reduce positive marginal domestic abatement costs. And,since measures with positive costs under a regime with restric-tions make up only a fraction of total mitigation under an effi-cient domestic policy, the quantitative significance of the Kyotomechanisms is greatly reduced. If access to the Kyoto mecha-nisms is given to individual sources, there arises the potential fora second principal-agent problem in that individual entities maymitigate in ways that minimize private costs but fail to minimizesocial costs in the national economy. In this case, both interna-tional efficiency and domestic efficiency are jeopardized.

6.4.2 Conflicts with International EnvironmentalRegulation and Trade Law

Compatibility of environmental protection with free tradeand/or investment has been important in both the environmen-tal and trade fields. The Committee on Trade and Environmentof the WTO has under discussion the relationships between theprovisions of the multilateral trading system and trade mea-sures for environmental purposes, including those pursuant tomultilateral environmental agreements (MEAs). Also underdiscussion are the relationships between environmental poli-cies and measures with significant trade effects and the provi-sions of the multilateral trading system. Some analysts suggestthat the WTO is not an appropriate forum to resolve these ques-tions and propose the establishment of a multilateral environ-mental organization for this purpose (Esty, 1994).

The UNFCCC is one of more than 200 multilateral and bilat-eral international environmental agreements (MEAs) whosecompatibility with free trade and investment is debated(UNEP, 1983, 1991). More than 20 MEAs incorporate explic-it trade measures.88 Other MEAs address the need to co-ordi-nate restrictions on conduct taken in compliance with obliga-tions they impose and the expanding regime of trade andinvestment law under the WTO/GATT umbrella.89 UNFCCCArticle 3.5 (UNFCCC, 1992), following GATT Article XX,stipulates that “Parties shall co-operate to promote a support-ive and open international economic system that would lead to


87 Only sources or sinks not subject to the tax are likely to be approvedas JI projects, to reduce the risk of double counting.

88 See Ward and Black (2000, p. 122). Some MEAs, like the 1973Convention on International Trade in Endangered Species (CITES,1973), the 1989 Basel Convention on the Control of TransboundaryMovements of Hazardous Waste (UNEP, 1989), or the 1987 MontrealProtocol on Substances that Deplete the Ozone Layer Articles, 4.1,4.2, and 4.3, restrict trade in polluting products or products that con-tain controlled substances (UNEP, 1987). Some, like MontrealProtocol Article 4.4, propose trade sanctions, but these are, however,not implemented, even on products manufactured with polluting sub-stances.

89 Agenda 21 (UN, 1992), Chapters 2.3, 2.11, 2.20 and 17; Principles11 and 12 of the Rio Convention; Convention on Biodiversity, Article22.1.

sustainable economic growth and development in all Parties ...Measures taken to combat climate change, including unilater-al ones, should not constitute a means of arbitrary or unjusti-fiable discrimination or a disguised restriction on internation-al trade.”

There are no presently cited cases of trade claims against mea-sures enacted in widely subscribed MEAs like the CITES orthe Montreal Protocol. Neither the UNFCCC nor the KyotoProtocol now provides for specific trade measures. The debateover conflicts between trade and MEAs stems from theprospect that trade-related measures might be enacted to limittrade in polluting products and in endangered species, or tradein goods created by means of polluting processes and produc-tion methods (PPMs). MEAs could also require general or spe-cific trade measures to sanction non-Parties to the MEA ornon-compliant MEA members.

IET under Article 17 of the Kyoto Protocol has raised questionsof WTO compatibility. Early analysis concludes that the rulesgoverning the transfer and mutual recognition of allowancesare not covered by WTO because they are neither products norservices (Werksman, 1999).90 However, several domestic poli-cies and measures that may be taken in conjunction with theKyoto Protocol might be considered to pose WTO problems,such as excessively restricting trade regulations, GATT-incon-sistent border charges, or illegal subsidies.91

National programmes of permit distribution for emissions trad-ing (see Section 6.2.2.3) or national environmental aid (subsi-dies) might benefit domestic firms or sectors over importers orforeign competitors (Black et al., 2000).92 In addition, a Partyor group of Parties (as part of the national implementation pro-

grammes) might apply taxes or environmental policies andmeasures in a way that arguably discriminates against WTOtrade partners. Environmental regulations, taxes, or voluntarymeasures could be challenged as indirect forms of protectionthat fall disproportionately on imported products. Recent casessuggest more cases could be argued under the agreement onTechnical Barriers to Trade (TBT) rather than GATT.93

Trade-related environmental measures traditionally pose prob-lems for the multilateral trading regime. Considerations of sov-ereignty favour the autonomy of WTO Parties to set health orenvironmental standards for all products, domestic or imported,consumed in their national territories. Each country has broaddiscretion to introduce its own policies and measures, includingenergy efficiency standards and import restrictions, to protect itsenvironment and/or its people’s health, subject to GATT Article3 (national treatment). However, more debatable is whetherGATT permits a government to place restrictions or bans on theimport of goods or services, themselves not dangerous or pol-luting, that are produced outside its borders through PPMs thatdo not meet its national environmental regulations or standards.PPM issues may be characterized as “clean products producedthrough dirty processes”. As MEAs increasingly utilize trademeasures to prevent non-members from free-riding, the consis-tency of such trade measures with the relevant GATT articles(Article XX, in particular) has been questioned when they arebased on the lack of corresponding PPM requirements in theexporting countries (Murase, 1995, 1996). At present, the rela-tion between WTO-compatible environmental measures andMEAs remains unsettled. It is also unclear whether WTO law isneutral in its treatment of alternative trade-related measures(e.g., standards, taxes, and subsidies).

Prior to 1995, when GATT 1994 replaced GATT 1947 underthe WTO agreement, six panel reports involved environmentalissues related to trade measures under Article XX (Ahn, 1999).The Appellate Body under the revised WTO dispute settlementsystem has since decided two further cases.94 While none ofthese disputes challenged the environmental objectives pur-


90 Black et al. (2000) note that if emissions trading is treated as afinancial service, there is no clear policy reason to exclude non-Partiesto the Kyoto Protocol from trading in these markets.

91 For example, a Party might impose equivalent product-specificenergy-efficiency standards on domestic and imported refrigerators orautomobiles. Or a Party might ban the domestic production andimport of rice grown under methane intensive cultivation methods orof wood harvested under non-sustainable forestry practices.Alternatively, a party might impose a tax on the carbon content ofdomestic and imported fuels or the carbon consumed in the productionof national and imported products. Finally, a Party might imposecountervailing duties against imports from nations that do not forcethe internalization of GHG emissions costs on national producers.

92 National energy policies have long been replete with distortionarysubsidies (Black et al., 2000, pp. 90–98). However, since even subsi-dies that encourage production below marginal factor costs haverarely been GATT challenged, it is unlikely that national policies thatfail to internalize full environmental costs will be GATT illegal, unlessthey explicitly discriminate between national production and imports.Energy efficiency subsidies to internalize environmental benefits are,in principle, permissible under the GATT subsidies code.

93 For example, when the EC concluded a voluntary agreement withACEA to reduce CO2 emissions from automobiles in February 1999,the Commission asked non-EU automobile manufactures to concludethe same kind of agreements, fearing that the European car manufac-turers might lose international competitiveness. As a result, inOctober 1999, the Japanese Automobile Manufacturing Association’svoluntary commitment to follow the same standards was approved bythe EU. When the Japanese government enacted an amendment tostrengthen fuel efficiencies of automobiles, both European andAmerican governments expressed their concern, through formal TBTprocedure, that it would become an invisible trade barrier for auto-mobile export. Also, when the EC intended to propose a Directive onWaste Electrical and Electronic Equipment, both the US and Japanesegovernments expressed the same concern.

94 Perkins (1999); see also United States -Standards for Reformulatedand Conventional Gasoline (World Trade Organization, 1996).

sued by the governments concerned, all rulings found that thecontested trade restrictions were in some respect discriminato-ry or unnecessarily trade restrictive. However, more recent rul-ings, including those of the Appellate Body, have narrowed orrejected earlier panel interpretations that had held PPMs eitherper se inconsistent with the intent of GATT or highly restrict-ed by the terms of Article XX.

The GATT Panel rulings in the Tuna–Dolphin I dispute readArticles XXb and XXg so as to preclude provisional justifica-tion for extraterritorial PPMs as inherently arbitrary measuresdestructive to the system of international trade.95 The panel inthe Shrimp–Turtle dispute also explicitly held that the USshrimp embargo belonged to the class of measures (PPMs) thatthreatened the multilateral trading system and therefore violat-ed the terms of the Chapeau of Article XX. However, the WTOAppellate Body overruled the Panel’s view in theShrimp–Turtle case. The WTO indicated implicitly that it doesnot categorically disallow the use of extrajurisdictionalPPMs.96 Although the import restrictions in question applied toshrimp harvesting practices and not to any characteristic of theshrimps themselves, the Appellate Body treated the measure asprovisionally justifiable. It considered the legality of the spe-cific restrictions, which were held to be invalid under the pro-hibition of the Chapeau of Article XX of discriminatory andarbitrary measures. The US embargo was ruled overly broad,its enforcement inflexible in considering the conservationeffects of other nations’ shrimping practices, disparate in itstreatment of other nations, deficient in due process, and putinto effect without sufficient good-faith efforts to secure widermultilateral acceptance of its exclusionary programme (Berger,1999).

Although as yet there is no universally accepted interpretationof the Shrimp–Turtle Appellate Body decision, some analystssuggest the holding implies PPMs no longer violate WTO bytheir very nature (Ahn, 1999). Others argue such a conclusionis premature legally or has been insufficiently debated and test-ed in the scientific literature (Jackson, 2000). In either case, theruling did not refer to important questions relevant to the inter-action of WTO and the UNFCCC and/or Kyoto Protocol. It isunclear whether national PPMs need only be enacted by Partiesto an MEA in their compliance programmes, or whether eachparticular PPM, its mode of application, and/or its sanctionscheme are the subjects of multilateral accord. Nor is it certainhow widely the multilateral agreement that supports the PPMmust be subscribed to make it WTO compatible.97

Parties to MEAs might base national climate programmes onpollution taxes rather than product or PPM standards. WTO

law does allow compensating charges or border adjustments tosimilar imported products to equalize the tax burden on domes-tic production. While direct taxes (wages, incomes) may not becompensated on imports or refunded on exports, certain indi-rect taxes, such as sales taxes or excises, may be adjusted at theborder.98 Indirect environmental taxes levied on a locally pol-luting product like imported fuel or gas guzzling automobiles,as long as not in excess of charges imposed on like domesticproducts, would be WTO consistent. Analogous indirect taxes,equal to domestic taxes, imposed on non-locally pollutingimports produced through foreign process and productionmethods that were environmentally damaging have beenapproved in the GATT dispute settlement process.99

Nevertheless, some border charges on products manufacturedthrough GHG-intensive PPMs might be WTO inconsistent.Although specific taxes on final products (e.g., fuels) and on“goods physically incorporated” into final products (e.g., afeedstock or catalyst) may be adjusted at the border, so-calledhidden taxes on inputs, such as transport, machinery, advertis-ing, or energy entirely consumed during production, have notbeen legally adjustable. Current practice is not fully symmetri-cal in its treatment of regulatory standards and taxes as envi-ronmental instruments.100


95 United States–Restrictions on Imports of Tuna (World TradeOrganization, 1994).

96 See Shrimp–Turtle decision, paragraphs 121 and 187b (World TradeOrganization, 1999); see also Perkins (1999, p. 119).

97 Nor is there yet guidance whether trade restrictions could beenforced against a UNFCCC party with differentiated responsibilitiesunder the MEA, even if WTO-legal restrictions against imports fromnon-Annex I Parties would confuse the meaning of “differentiatedresponsibilities”.

98 Economists have long noted the lack of precision of the categoriesdirect and indirect taxes, as well as the dependence of the ability topass on the incidence of taxes to consumers (indirect taxes) on mar-ket structure. However, the terms continue to be applied with reason-able ease in legal practice (Demaret and Stewardson, 1994, pp.14–16).

99 In the Superfund Tax case, US border charges on certain waste cre-ating feedstock chemicals used as inputs in the processing of import-ed chemical derivative products were ruled to be legal. These bordercharges, equal to taxes imposed on similar US feedstock, were heldvalid even though there was no transboundary damage outside thenation of origin (World Trade Organization, 1988). A border tax onshrimp caught with turtle-unsafe methods and similar to a domestictax on such products would seem to fall under this rule. Products thathave been produced through differential production methods, likeproducts that have different environmental qualities in themselves,have usually been considered to be not “like products” and thereforeallowable objects of differential, non-discriminatory taxes (Demaretand Stewardson, 1994, pp. 34–41).

100 A limited amendment to the treatment of energy taxes was madein the Uruguay 1994 Agreement on Subsidies and CountervailingMeasures. Border adjustments were allowed for those nations thatstill imposed cumulative prior-stage indirect taxes on “energy, fuels,and oil used in the production process”. This exception to the hiddentax rule was intended to cover only a limited set of nations (Demaretand Stewardson, 1994, pp. 29–30).

6.4.3 International Co-ordination of Policy Packages

When developing domestic policies to meet their emissionslimitation commitments under the Kyoto Protocol, someAnnex I Parties may wish, or be under pressure, to impose lessstringent obligations on some industries to improve their com-petitiveness. The sensitivity of industry location to the strin-gency of environmental regulation is called “ecological dump-ing”. International co-ordination of environmental policiesmay be needed to reach an economically efficient outcome inwhich it is impossible to make one country better off withoutmaking at least one other country worse off.

Under certain ideal conditions (e.g., perfect competition in allmarkets) there is theoretically no need for international policyco-ordination (Oates and Schwab, 1988). However, such condi-tions do not hold if there is imperfect competition in goods mar-kets or unemployment (Rauscher, 1991, 1994; Barrett, 1994;Kennedy, 1994; A. Ulph, 1994; D. Ulph, 1994). If, and to whatextent, international differences in environmental regulationhave trade or even relocation implications obviously depends ona host of factors. These include country size, availability ofalternatives, relative resource endowment, mobility of produc-tion factors, competition level, scope for innovation, possibilityof border-tax adjustment, chances of retaliation, and redistribu-tion of environmental tax revenues (OECD, 1996a).

Although it is clear that many factors affect the relationshipbetween the stringency of pollution control policies (if imple-mented unilaterally) and net exports, some authors have car-ried out rather straightforward empirical tests on the relation-ship between the two variables. Han and Braden (1996) exam-ined 19 US manufacturing industries between 1973 and 1990with the help of regression analysis. They found the relation-ship between pollution abatement costs and net exports to benegative in most of the sample period, but diminishing overtime (with elasticities close to zero in many industries). VanBeers and Van den Bergh (1997), using a gravity model ofinternational trade and two measures of environmental strin-gency, did not find a significant relationship between environ-mental stringency and total exports for the “dirty” industries.However, when they focused on the non-resource based, andtherefore more “mobile”, industries only this relationship wassignificant.

Early empirical research on the impact of environmental poli-cy on trade found little evidence of a measurable relationship,partly because of low environmental taxes and partly throughdata and statistical limitations. Therefore, many studies haveconcentrated on simulations of environmental tax regimes.From a survey of these studies, IPCC’s SAR (IPCC, 1996) con-cluded that estimates of the effects of environmental policies(notably carbon taxes) on trade vary wildly, depending onmodel parameters (such as energy demand elasticities andassumptions regarding the substitutability of traded goods) andthe policy scenario examined (extent of reduction in emissionsand extent of international co-ordination).

Various partial equilibrium models have been designed to ana-lyze ecological dumping, many using static or dynamic gametheory. Early analyses used a Cournot setting, which modelslong-run competition among firms as a series of strategiccapacity or output choices. The general conclusion from theseearly models is that the optimal tax (or any comparable domes-tic environmental policy instrument) would be set below mar-ginal damage. As a consequence, environmental policies aredesigned to try to protect domestic industries. If producers col-lude, however, the incentive for governments to engage in eco-logical dumping is reduced (Ulph, 1993).

The ecological dumping conclusion could change completelyif governments act strategically in setting taxes, and if there isBertrand competition (firms compete by choosing the price tocharge, rather than the quantity to produce) instead of Cournotcompetition (Eaton and Grossman, 1986; Barrett, 1994;Conrad, 1996; Ulph, 1996). If, however, producers act strate-gically or can collude, then the outcome in terms of ecologicaldumping is not straightforward. Quantity-based environmentalregulation, if implemented unilaterally in a duopolistic casewith a domestic and foreign supplier, might actually benefitdomestic firms at the cost of domestic consumers (Kooiman,1998). If both governments and producers act strategically,again, the incentive for governments to distort the environ-mental policy is less than when only governments acted strate-gically, so that the Bertrand outcome can be similar to theCournot outcome (Ulph, 1996).

Ecological dumping also has been analyzed with the help of gen-eral equilibrium models of international trade involving exter-nalities (Rauscher, 1994). It was shown that in a second-bestworld for several market structures–monopoly power of theexposed sector or oligopoly on an outside market (Elbers andWithagen, 1999)–ecological dumping might not (always) be ben-eficial from a welfare point of view. This is contrary to the con-clusions of some of the earlier partial equilibrium models,

The most interesting case for analyzing policy co-ordinationneeds is that in which national commitments have been decidedinternationally, but individual Parties may, but need not, co-ordi-nate their national policies to fulfil their commitments. Thiswould be the Kyoto Protocol case, after ratification. Hoel (1997)has addressed this case and argues that governments may tend tosubsidize indirectly particular imperfectly competitive industriesselling on the international market. To prevent this from happen-ing, an argument can be made in favour of policy co-ordination,which is possible but not required in the Kyoto Protocol, exceptinsofar as the Kyoto mechanisms are concerned.101

6.4.4 Equity, Participation, and International PolicyInstruments

The participation of developing countries and EITs in theUNFCCC is important, since these countries are both largefuture emitters of carbon, and sources and potential sources of


low-cost abatement investments (McKibbin and Wilcoxen,2000). Since the participation of regions with low marginalabatement costs may be critical for aggregate cost and emis-sions reduction, encouraging their participation may require aserious consideration of the equity implication of that policy(Morrisette and Plantinga, 1991). Unlike efficiency, there is nouniversal consensus definition of equity by which policyinstruments can be evaluated. Recent research on equity, how-ever, analyzed the welfare impacts of climate policy alterna-tives to understand the participation incentives (for differentcountries and regions) of various policy instruments (Bohmand Larsen, 1994; Edmonds et al., 1995; Rose et al., 1998).

The types and structures of mechanisms adopted (such as uni-form taxes, tradable quota, or individual non-tradable targets)affect the scope and timing of participation in some predictableways (Edmonds et al., 1995). For example, individual non-tradable targets based on the stabilization of national emissionswould shift more than 80% of aggregate costs to non-OECDregions by 2020, making it unlikely that these regions wouldparticipate in such an agreement (Edmonds et al., 1995).

Alternatively, with a common global carbon tax and full par-ticipation, the burden of abatement costs would be distributedunevenly across the world and would change with time. A largeburden would fall on OECD and economies in transition in theearly years, shifting to developing nations in later years(Edmonds et al., 1995). Transition economies would thus beunlikely to participate in a common global carbon tax agree-ment. If such nations were to participate in the short run,growth and changing economic and political circumstancesmay increase the probability of their dropping out of a taxagreement when they face increasing net participation costs(Edmonds et al., 1995).

The equity implications of a global tradable quota systemdepend on quota allocation. The portion of global abatementcosts borne by a country or group of countries depends on itsrelative position in the quota market; net sellers of quota effec-tively receive income transfers from net buyers. Table 6.3describes the relative position of groups of countries in aninternational quota market, based on six possible initial alloca-tions (Edmonds et al., 1995).102

Of course, a country’s participation in an allocation schemedepends on net costs (the sum of transfer payments associatedwith quota trade, plus direct mitigation costs), not just thedirection of income transfers. However, that the direction oftransfers may change over time, especially for China and thetransition economies, complicates the incorporation of equitygoals in quota system design (Edmonds et al., 1995). Althoughquota allocation is referred to here, the analysis applies equiv-alently to redistributing international carbon tax revenues(Pezzey, 1992; Rose et al., 1998).

Bohm and Larsen (1994) explore the participation implicationsof two of the more frequently discussed of the allocationschemes listed in Table 6.3 (allocation by population and byGDP) for a quota regime covering Western Europe and EasternEurope. Both of these allocations, and combinations thereof, leadto substantial losses by the Eastern European countries, makingtheir participation unlikely (Bohm and Larsen, 1994). Given theaggregate cost-savings associated with their participation, anideal allocation system would provide the minimum possibleparticipation incentive to the Eastern European countries, whilemaximizing potential abatement cost savings to the westerncountries. The authors identify this lower bound in terms of east-ern country quota-to-emissions ratios that would induce partici-pation, ranging among countries from 0.85 to 0.91. This incen-tive scenario results in zero net gains (losses) to the eastern coun-tries, and net costs to each western country of 0.09% of GDP. Inthe presence of wide disparity in current regional economic wel-fare, the perceived equity benefits of such a scenario may facili-tate a more cost-effective agreement than any that might beachieved without Eastern European participation.103

If quota allocations are used to induce participation by transi-tion economies and developing countries, the internationalwealth transfers that occur as a result may cause fluctuations inreal exchange rates and international capital and trade flows(McKibbin and Wilcoxen, 1997a, 1997b). The magnitude ofthese fluctuations and the extent to which they could be prob-lematic are uncertain. McKibbin and Wilcoxen (2000) suggestan alternative approach to the problem of equity versus partic-ipation incentive, which includes both short-run emissionsquota and long-run emissions “endowments”. In this approach,the price of emissions quota is set through international nego-tiation at regular intervals (they suggest every decade), andeach country issues as many quotas as necessary to keep theprice at the negotiated level. The price of emissions endow-ments, however, is flexible, and the quantity allowed per coun-try is fixed. Each participating country’s endowment pricesreflect expected future prices of emissions quota.


101 Hoel (1997) uses a simple model of a group of identical countriesthat interact through mobile real capital. Given the total stock of realcapital for the group of countries as a whole, he demonstrates that ifcompetition in the goods markets is imperfect or if unemploymentexists, a lack of international policy co-ordination may lead to out-comes that are not Pareto optimal. However, he finds there is no needfor policy co-ordination if after-tax wages are exogenous, but thisseems to be a rather strong assumption.

102 Rose et al. (1998) analyzed the welfare impacts of various tradablepermit allocations and obtained results that are consistent with manyof the results of Edmonds et al. (1995).

103 GDP per capita in 1989 ranged from US$1,200–1,500 in Albania,Turkey, Tajikistan, and Uzbekistan to more than US$20,000 inSwitzerland, Luxembourg, and the Scandinavian countries (Bohmand Larsen, 1994).

6.5 Key Considerations

This section deals with the most important aspects that couldbe considered in designing climate change policy.

6.5.1 Price versus Quantity Instruments

Optimal climate change policy–irrespective of whether it isnational or international–under uncertainty and/or asymmetricinformation deviates from more typical analyses with best-guess parameter values and/or information symmetry, not onlyin terms of the stringency of policies, but also in terms of pol-icy design (Weitzman, 1974). Depending on the degree ofuncertainty and correlation between the marginal damage andMAC curves, taxes could be a better or inferior alternative totradable permits (Watson and Ridker, 1984; Stavins, 1996).104

Recent literature shows that taxes dominate quotas for the con-trol of GHGs when the environmental damage function israther flat (Hoel and Karp, 1998). Hoel (1998) and Pizer(1997b) point out that the lack of a clear, short-term thresholdfor severe climate damages favours the use of market-based

policies, like taxes, that limit cost uncertainty. In addition,there is mounting evidence that rigid emission limits are notappropriate in the short run under a weak emissions reductionregime (Newell and Pizer, 1998).

Recently, Pizer (1997a) argued that excluding uncertaintymight lead to policy recommendations that are too lax. Ebert(1996) has argued that improving the information of the regu-lator is crucial, because decision makers always overestimateabatement costs if they neglect that firms possess an abatementoption other than decreasing output–additional abatement tech-nology.

To increase the effectiveness and efficiency of domestic GHGemissions reduction policies, it is argued that governmentscould adopt policies that take a comprehensive approach, stim-ulating the development of all kinds of new materials, materi-als substitution, product re-design, resource productivity, andwaste management strategies that can reduce GHG emissions.Moreover, governments could set long-term GHG emissionsreduction targets, since the optimal set of technical options atlow GHG mitigation levels may not include options that areefficient at high GHG emissions reduction levels.


Table 6.3: Direction of income transfers in international emissions trading, six possible quota allocation schemes

Anticipated position of participating countries, 2005-2095

Tradable quota allocation OECD EITs China and other Rest of worldcountries centrally-planned

Asian countries

Grandfathering Net sellers Net sellers Net buyers Net buyers

Equal per-capita emissions Net buyers Net buyers Net sellers early,Net buyers post-2035

GDP-weighted emissions Net sellers Net effect small Net buyers Net effect smalland ambiguous and ambiguous

GDP-adjusted grandfathering Net buyers Net sellers Net effect small Net effect small and ambiguous and ambiguous

No harm to developing nations Net buyers Net sellers early, net Net sellers Net sellersbuyers post-2035

No harm to non-OECD nations Net buyers Net sellers early, net Net sellers Net sellersbuyers post-2035

Source: Edmonds et al. (1995).

Notes: Under GDP-adjusted grandfathering, emissions rights have a baseline at current levels, adjusted for income growth. The “no harm” scenarios

allocate sufficient quota to the relevant countries to cover their own emissions and to generate enough revenue to cover economic costs of protocol par-

ticipation.

104 Montero (2000b) finds that under incomplete enforcement tradablepermits perform relatively better than taxes.

6.5.2 Interactions of Policy Instruments with FiscalSystems

It is important to consider how the domestic policy instrumentsexamined in this chapter may interact with existing fiscal sys-tems, because such interactions can have significant effects onthe overall costs of achieving specified GHG emissions reduc-tion targets. A growing literature demonstrates theoretically,and with numerical simulation models, that the costs ofaddressing GHG targets with policy instruments of allkinds–command-and-control as well as market-basedapproaches–can be greater than anticipated because of theinteraction of these policy instruments with existing domestictax systems.105 Domestic taxes on labour and investmentincome change the economic returns to labour and capital, anddistort the efficient use of these resources.

The cost-increasing interaction reflects the impact that GHGpolicies can have on the functioning of labour and capital mar-kets through their effects on real wages and the real return tocapital (see, e.g., Parry et al., 1999). By restricting the allow-able GHG emissions, permits, regulations, or a carbon tax raisethe costs of production and the price of output, thus reducingthe real return to labour and capital, and exacerbating prior dis-tortions in the labour and capital markets. Thus, to attain agiven GHG emissions target, before or after use of IET andother Kyoto mechanisms, all the instruments have a cost-increasing “interaction effect”.

For policies that raise revenue for the government, carbontaxes and auctioned permits, this is only part of the story, how-ever. These revenues can be recycled to reduce existing distor-tionary taxes. Thus, to attain a given GHG emissions target,revenue-generating policy instruments have the advantage of apotential cost-reducing “revenue-recycling effect” as com-pared to the alternative, non-auctioned tradable permits orother non-revenue-generating instruments (Bohm, 1998). For amore complete theoretical discussion, see Chapter 7, and seeChapter 8 for the empirical results.

6.5.3 The Effects of Alternative Policy Instruments onTechnological Change

In the long run, the development and widespread adoption ofnew technologies can greatly ameliorate what, in the short run,sometimes appear to be overwhelming conflicts between eco-nomic well being and environmental quality. Therefore, theeffect of public policies on the development and spread of newtechnologies may be among the most important determinantsof success or failure in environmental protection (Kneese andSchultze, 1975).

To achieve widespread benefits from a new technology, threesteps are required (Schumpeter, 1942):

• invention, the development of a new technical idea;• innovation, the incorporation of a new idea into a com-

mercial product or process and the first marketplaceimplementation thereof; and

• diffusion, the typically gradual process by whichimproved products or processes become widely used.

Rates of invention, innovation, and technology diffusion areaffected by opportunities that exist for firms and individuals toprofit from investing in research, in commercial development,and in marketing and product development (Stoneman, 1983).

Governments often seek to influence each of these directly, byinvestment in public research, subsidies to research and tech-nological development, dissemination of information, andother means (Mowery and Rosenberg, 1989). Policies withlarge economic impacts, such as those intended to addressglobal climate change, can be designed to foster technologicalinvention, innovation, and diffusion (Kemp and Soete, 1990).For the impact of R&D policies on technology developmentand transfer, see the IPCC Special Report on TechnologyTransfer (IPCC, 2000).

To examine the link between policy instruments and techno-logical change, environmental policies can be characterized asmarket-based approaches, performance standards, technologystandards, and voluntary agreements. All these forms of inter-vention have the potential to induce or force some amount oftechnological change, because by their very nature they induceor require firms to do things they would not otherwise do.Performance and technology standards can be explicitlydesigned to be “technology forcing”, mandating performancelevels that are not currently viewed as technologically feasibleor mandating technologies that are not fully developed. Theproblem with this approach can be that while regulators typi-cally assume that some amount of improvement over existingtechnology will always be feasible, it is impossible to knowhow much. Standards must either be made not very ambitious,or else run the risk of being ultimately unachievable, whichleads to great political and economic disruption (Freeman andHaveman, 1972). However, in the case of obstructed technolo-gy, regulators know quite well the technology improvementsthat are feasible. Thus, although the problem of standardsbeing either too low or too ambitious remains a possibility, itdoes not make standards inherently incapable of implementingsome portion of the available technology base, and to do socost-effectively on the basis of cost–benefit tests.106


105 For the basic analysis and economic intuition of this literature, seeKolstad (2000, pp. 281–284).

106 There is, however, an interesting example in which ambitious stan-dards were finally achieved. New emission standards for passengercars (the so-called “Muskie” standard), when first enacted in the USAin 1970, were thought to be too ambitious because no such technolo-gies existed in the world. However, a technology breakthrough by twoautomobile manufacturers in Japan achieved the standard (Honma,1978; OECD, 1978).

6.5.3.1 Theoretical Analyses

Most of the work in the environmental economics literature onthe dynamic effects of policy instruments on technologicalchange has been theoretical, rather than empirical, and the the-oretical literature is considered first. The predominant theoret-ical framework involves what could be called the “discretetechnology choice” model. In this, firms contemplate the use ofa certain technology that reduces the marginal costs of pollu-tion abatement and that has a known fixed cost (Downing andWhite, 1986; Jung et al., 1996; Malueg, 1989; Milliman andPrince, 1989; Zerbe, 1970).

While some authors present this approach as a model of inno-vation, it is perhaps more useful as a model of adoption.107 Theadoption decision is one in which firms face a given technolo-gy with a known fixed cost and certain consequences, and mustdecide whether or not to use it; this corresponds precisely tothe discrete technology choice model. Innovation, on the otherhand, involves choices about research and development expen-ditures, with some uncertainty over the technology that willresult and the costs of developing it. Models of innovationallow firms to choose their research and development expendi-tures, as in Magat (1978, 1979), or incorporate uncertainty overthe outcome of research (Biglaiser and Horowitz, 1995;Biglaiser et al., 1995).

Several researchers have found that the incentive to adopt newtechnologies is greater under market-based instruments thanunder direct regulation (Downing and White, 1986; Jung et al.,1996; Milliman and Prince, 1989; Zerbe, 1970). This view istempered by Malueg (1989), who points out that the adoptionincentive under a freely allocated tradable permits systemdepends on whether a firm is a buyer or seller of permits. Forpermit buyers, the incentive is larger under a performance stan-dard than under tradable permits.

Comparisons among market-based instruments are less consis-tent. Downing and White (1986), who consider the case of asingle (sole) polluter, argue that taxes and tradable permit sys-tems are essentially equivalent. On the other hand, Millimanand Prince (1989) find that auctioned permits provide thelargest adoption incentive of any instrument, with emissionstaxes and subsidies second, and freely allocated permits anddirect controls last. Jung et al. (1996) consider heterogeneousfirms, and model the “market-level incentive” created by vari-ous instruments. This measure is simply the aggregate cost sav-ings to the industry as a whole from adopting the technology.Their rankings echo those of Milliman and Prince (1989).

On the basis of an analytical and numerical comparison of thewelfare impacts of alternative policy instruments in the pres-ence of endogenous technological change, Fischer et al. (1998)argue that the relative ranking of policy instruments dependscritically on firms’ ability to imitate innovations, innovationcosts, environmental benefit functions, and the number offirms that produce emissions.108 Finally, the study includes anexplicit model of the final output market, and finds that itdepends upon empirical values of the relevant parameterswhether (auctioned) permits or taxes provide a stronger incen-tive to adopt an improved technology.

Finally, recent research investigates the combined effect of thepollution externality and the positive externality that resultsfrom learning-by-doing with mitigation technologies. Since thebenefit from learning occurs after the learning has taken place,a dynamic analysis is needed. Some analyses shown thatdynamic efficiency (discounted least cost, aggregated overtime) requires that the incentive for emissions-mitigating inno-vations be set higher than the penalty on emissions, especial-ly if account is taken of “leakage”. This is in contrast with theconclusions of comparative static analysis upon which mostenvironmental policy analysis is grounded (e.g., Baumol andOates, 1988), under which the two incentives should be equalin all time periods (for a formal analysis, see Read (1999,2000)).

6.5.3.2 Empirical Analyses

Empirical analyses109 of the relative effects of alternative envi-ronmental policy instruments on the rate and direction of tech-nological change are limited in number, but those availablefocus on technological change in energy efficiency, and thusare potentially of direct relevance to global climate policy.These studies can be considered within the three stages of tech-nological change introduced above–invention, innovation, anddiffusion. It is most illuminating, however, to consider thethree stages in reverse order.

Beginning, then, with empirical analyses of the effects of envi-ronmental policy instruments on technology diffusion, Jaffeand Stavins (1995) conducted econometric analyses of the fac-tors that affected the adoption of thermal insulation technolo-gies in new residential construction in the USA from 1979 to1988. They examined the dynamic effects of energy prices andtechnology adoption costs on average residential energy-effi-cient technologies in new home construction. The effects of


107 Zerbe (1970) couches his research in terms of adoption. Downingand White (1986) frame their work in terms of innovation. Millimanand Prince (1989) use one model to discuss both diffusion and inno-vation, the latter being defined essentially as the initial use of the tech-nology by an “innovating” firm. Malueg (1989) presents the sameframework as a model of adoption. Jung et al. (1996) present theirmodel as one of either adoption or innovation.

108 Related to this is the finding of Parry (1998) that the welfare gaininduced by an emissions tax is significantly greater than that inducedby other policies only for very major innovations. Also related isMontero’s (2000c) conclusion that the relative superiority of alterna-tive policy instruments in terms of their effects on firm investments inR&D depends upon the nature of the underlying market structure.This is implied by Laffont and Tirole (1996).

109 For further literature references, see Chapter 8.

energy prices can be interpreted as suggesting what the likelyeffects of taxes on energy use would be, and the effects ofchanges in adoption costs can be interpreted as indicating whatthe effects of technology-adoption subsidies would be. Theyfound that the response of mean energy efficiency to energyprice changes was positive and significant, both statisticallyand economically. Interestingly, they also found that equivalentpercentage cost subsidies would have been about three times aseffective as taxes in encouraging adoption, although standardfinancial analysis suggest they ought to be about equal in per-centage terms. This finding does, however, offer confirmationfor the conventional wisdom that technology adoption deci-sions are more sensitive to up-front cost considerations than tolonger-term operating expenses.

In a study of residential conservation investment tax credits,Hassett and Metcalf (1995) also found that tax credit or deduc-tions were many times more effective than “equivalent”changes in energy prices–about eight times as effective in theirstudy. They speculate that one reason for this difference is thatenergy price movements may be perceived as temporary. Thefindings by Jaffe and Stavins (1995), and by Hasset andMetcalf (1995) are consistent with other analyses of the rela-tive effectiveness of energy prices and technology marketreforms in bringing about the adoption of lifecycle cost-savingtechnologies. Up-front subsidies can be more effective thanenergy price signals (see, e.g., Krause et al., 1993; Howarthand Winslow, 1994; IPSEP, 1995; Eto et al., 1996; Golove andEto, 1995; IPCC, 1996, Executive Summary, p. 13). A disad-vantage of such non-price policies relative to administeredprices is that they have to be implemented on an “end-use byend-use” or “sector by sector” basis in a customized fashion.Also, an effective institutional and regulatory frameworkneeds to be created and maintained to evaluate and ensure thecontinued cost-effectiveness of such policies.

This and other research on energy efficiency programmes alsohighlights a major difference in the way energy price signalsand technology subsidies function. The technology adoptionresponse to taxes may include a secondary increase in thedemand for energy services. This secondary effect takes twoforms: a direct effect that results from the increased utilizationof energy-using equipment and capital stocks, and an indirecteffect from increased disposable income. Studies of suchdemand effects suggest that the combined effects are general-ly not sufficient to offset more than a minor portion of emis-sions reductions.

In addition, technology subsidies and tax credits can requirelarge public expenditures per unit of effect, since consumerswho would have purchased the product even in the absence ofthe subsidy will still receive it.110

Some recent empirical studies suggest that the response of rel-evant technological change to energy price changes can be sur-prisingly swift. Typically, this is less than 5 years for much ofthe response in terms of patenting activity and the introductionof new model offerings (Jaffe and Stavins, 1995; Newell et al.,1999; Poppe, 1999). Substantial diffusion can sometimes takelonger, depending on the rate of retirement of previouslyinstalled equipment. The longevity of much energy-usingequipment reinforces the importance of taking a longer-termview towards energy-efficiency improvements–on the order ofdecades.

An optimal set of policies would be designed in such a way asto achieve two outcomes simultaneously: release any obstruct-ed emission and cost-reduction potentials from already avail-able technologies through various market reforms that try toreduce market distortions (see IPCC, 2000), and induce theaccelerated development of new technologies. This approachallows significant carbon abatement over the near-term by dif-fusing existing technologies, while at the same time preparingnew technologies for the longer term.

6.6 Climate Policy Evaluation

Theoretically, it is unnecessary to monitor and evaluate nation-al policies and programmes to see whether Annex I Parties ful-fil their Kyoto commitments, provided national communica-tions give a clear and reliable picture of the net impact of thoseactions on the net national GHG emissions and net uptake viasinks. Indeed, national inventories, usually updated on anannual basis, are the backbone of the monitoring system. Ofcourse, governments might want to monitor the impact of theirown policies for domestic assessment purposes. To meet theinternational commitments, such monitoring, however, wouldnot be necessary if monitoring at the aggregate level were com-pletely reliable. However, this may not be true. Evidence sug-gests that there can be a considerable margin of error in thenational data provided to the UNFCCC Secretariat within theframework of the national communications.

Over the past 25 years an extensive literature, including pro-gramme evaluation, value-for-money audits, and comprehen-sive audits, has developed on the evaluation of governmentprogrammes. Much of this literature is specific to the type ofprogramme–low-income housing, training, employment cre-ation, policing, transit, energy efficiency, etc.–and has little rel-evance to the monitoring and evaluation of policies for climatechange mitigation. However, the literature also includesnumerous evaluations of energy-efficiency, DSM, emissionstrading, environmental taxes, and other programmes that couldprovide useful insights into the design, monitoring, and evalu-ation of climate change policies.


110 It may be possible to reduce the number of free-riders through subsidy programme design.

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